After yesterday's last minute decision by Italy's ruling coalition to boost the country's 2019 deficit to 2.4% of GDP, a number that challenged Brussels and its demands for a deficit no greater than 2.0% and made a mockery of the finance minister's insistence on a funding hole no greater than 1.6% of GDP, we said that it was only a matter of time before the market freaked out as Italy is now on collision course with Europe, and that time came this morning when traders dumped Italian assets with the bathwater, as Italian equities, bank stocks and bonds all tumbled in unison after deputy premier Matteo Salvini vowed to "press ahead" with the controversial budget plan including a deficit that would be three times larger than the deficit under the previous administration.
Italy's FTSE MIB stock index tumbled to session lows, down 3.7%, after opening sharply lower and failing to find a floor so far; this was the biggest intraday drop for Italian stocks since June 2016, with several banking stocks halted limit down.
The worst performing sector were Italian banks, with the FTSE Italia All-Share Banks Index falling as much as 5.3%, most since May; the biggest decliners were Banco BPM -6%, UBI -4.7%, UniCredit -3.9%, Intesa -3.5%, with most of them being halted, limit down amid the selling chaos.
The bond market was not spared, and Italy's 10Y bond was taken to the cleaners as the relentless selling sent the yield some 36bps higher to 3.25%...
... surpassing the peaks hit during the recent two Italian liquidation panics.
Italian debt had been volatile in recent days, but rallied for much of September in anticipation economy minister Giovanni Tria would reel in the government’s spending plans. That failed to happen last night when Tria capitulated to demands by Salvini and Di Maio to boost the deficit to support populist promises for basic income which would cost some €10 billion.
Aberdeen Investments' James Athey said he did not believe the Italian sell-off would necessarily start to “feed on itself” just yet. Nonetheless, he said investors would need greater compensation for holding Italian debt given the higher borrowing levels implied by the new budget, adding that the mood has clearly changed.
“It’s interesting that the first couple of pieces I read from the sell side today are from people who were bullish Italy and are now looking for bearish Italian trades,” he said. “The next three to six months are clearly going to be challenging. We are short and we’re staying short.”
Alternatively, the next 3 to 6 hours may be just as challenger, because the accelerating Italian selloff sent shockwaves around Europe, and led to an acceleration in the selling of the Euro which hit session lows, down over 200 pips in the past two days.
The key driver behind the market's panicked response is the unknown of how a furious Europe will respond to the Italian defiance, in which the newly elected populist government is now in open confrontation that could ultimately threaten the existence of the euro.
As the FT notes, with the Continent still reeling from a debt crisis that saw the collapse of the Cypriot banking system and nearly led to rebellious Greeks to abandon the Euro, the European Commission fears that an explosion of debt ushered in by Italy's ruling coalition - which includes the far-right, anti-immigrant League and anti-establishment Five Star Movement - could lead to international investors losing confidence in the eurozone and - more importantly - its debt.
Meanwhile, far from expressing concern, the budget agreement was celebrated by leaders in the coalition Italian government. Luigi Di Maio, the 32-year-old leader of the anti-establishment Five Star Movement, the largest party in the populist coalition, was greeted by a crowd of cheering party members waving flags after emerging from a cabinet meeting on Thursday night.
Di Maio hailed the agreement as a “historic day”. “We made it!” he said, as he emerged from a balcony at Rome’s Palazzo Chigi, where the meeting took place.
"Today we have changed Italy! For the first time the state is on the side of the citizens,” he added, as ministers and members of parliament from his party hugged each other on the square outside.
Matteo Salvini, leader of the hard-right League, part of the coalition and deputy prime minister alongside Mr Di Maio, also welcomed the agreement on spending, saying he was “fully satisfied with the objectives achieved”, which would include his party’s pledges for tax cuts and a reversal of unpopular pension reforms dating back to 2011.
All eyes were on technocratic finmin Giovanni Tria, who had been pressing for a deficit number as low as 1.6% of GDP going into the meeting. On Thursday night, Tria said that he would not resign, and instead would stay according to newspaper la Repubblica reports: "I won’t quit, just for the good of the country, I will do it for patriotism. Otherwise there would be the risk of a financial storm. We would throw the country into chaos,” Tria said.
Still, “the fact that the final agreement sees spending plans three times the initial projections for 2019 . . . very much suggests that Tria does not command the level of influence he was thought to have had,” wrote analysts at Rabobank.
At the same time, strategists at Commerzbank cautioned that while a 2.4% budget deficit need not trigger a new “escalation” for Italian bonds, the reality is that Tria, a former academic who is widely seen as a moderating force in the government, has been weakened and that the “risk and reward” has shifted for investors.
For now the Italian contagion has been limited, and while yields on Spanish and Portuguese government debt also rose on Friday, the moves were far more muted. The yield on 10-year Spanish bonds edged up 2 basis points to 1.52 per cent as that on the equivalent Portuguese bond rose 2bp to 1.87 per cent. However, should the Italian selling accelerate, it is unlikely that the selling panic will remain within Italy's borders.