Italian Bonds Show Euro ‘exit’ Fears Still Rumble Below The Surface

The European Central Bank long ago declared the euro “irreversible.” The two antiestablishment parties looking to form Italy’s next government apparently aren’t convinced.

A leaked draft of an agreement between the 5 Star Movement and the League that called for policies that would run up the countries budget deficit and debt load while pressing the European Union to come up with a procedure for allowing countries to leave the eurozone sent Italian stocks and, more important, government bonds skidding on Wednesday.

See: Italy’s markets spooked as antiestablishment agenda fuels fears of ‘new crisis’

The yield on the 10-year Italian government bond TMBMKIT-10Y, >+2.54%  jumped more than 15 basis points, according to FactSet, to 2.104%, touching a four-month high. Yields and bond prices move in opposite directions. The euro EURUSD, >+0.1592%  was off 0.5% at $1.1783 versus the dollar, while Italy’s FTSE MIB stock index I945, >-0.30%  fell more than 2%.

The yield premium demanded by investors to hold the Italian 10-year over its German TMBMKDE-10Y, >-22.02%  jumped by nearly 18 basis points to nearly 1.49 percentage points, also the highest since January.

It was the call for an exit procedure that was the most striking, said Jack Allen, European economist at Capital Economics, in a note.

The parties had toned down their anti-euro rhetoric in the run-up to the election last March, whose inconclusive result has led to months of wrangling that now has League and Five Star on the verge of forming a government. The draft proposal would call for an exit procedure in cases where leaving reflects “clear popular will,” Allen said, noting that opinion polls suggest that doesn’t apply at present in Italy.

Moreover, the parties are said to have dropped the proposal from their discussions, he said, which may explain why the market reaction hasn’t been more pronounced.

But investors shouldn’t rest easy, said Allen, as it shows that anti-euro sentiment continues to bubble below the surface in the two parties most likely to form a new government. Moreover, “it would not be surprising to see the proposal revived at some point in the futures, perhaps if Italy’s economy continues to underperform or if the EU refuses to budge on its fiscal rules,” he said, in a note.

Italian borrowing costs are nowhere near the nightmare levels seen during the darkest days of the eurozone debt crisis in 2011 and 2012, when even the 2-year yield briefly topped an unsustainable 7%. Yields later retreated, with ECB President Mario Draghi’s 2012 pledge to do “whatever it takes” to preserve the euro and the eventual formulation of a never-used program of emergency bond purchases serving to calm fears. Later, the ECB’s introduction of bond buying via its quantitative easing strategy helped drive yields lower across the eurozone.

Overall, however, the combination of not-so-latent euroskepticism and fiscal policies that would worry investors and set up a clash with Brussels might be enough to give Italian bond bulls reason to pause.

“All this suggests that there is a serious risk of a sustained selloff in Italy’s bond yields over the coming years,” Allen said.

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William Watts is MarketWatch's deputy markets editor, based in New York. Follow him on Twitter @wlwatts.

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Source : https://www.marketwatch.com/story/italian-bonds-show-euro-exit-fears-still-rumble-below-the-surface-2018-05-16

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