Italian bond sell-off worsens amid political tension

The sell-off in Italian bonds intensified on Tuesday, driving the benchmark 10-year yield above 2 per cent for the first time since Italy’s elections in March.

The 10-year yield hit 2.12 per cent and Milan’s stock market lost 2.5 per cent after reports that the country’s coalition negotiations could produce a government that breaks with economic orthodoxy.

The FTSE Mib has subsequently recovered slightly and is down 2.3 per cent on the day.

Bond yields, however, have consolidated at over 2.1 per cent after briefly hitting a high of 2.12 per cent – a 17 basis point move on the day, and the biggest upward move for more than two years.

The gap between 10-year German and Italian bond yields — a widely-watched indicator of eurozone political stress — briefly hit 150 basis points, up from 129 bps late on Tuesday and its widest level since January.

Other peripheral eurozone economies also saw their bond yields tick upwards, with the 10-year Portuguese yield rising by 5bps and the Spanish equivalent up 3bps The euro was also weighed down by the Italian political drame, falling 0.5 per cent against the dollar.

The Five Star Movement and the League, which are in talks to form a government, were considering asking the ECB to forgive €250bn of the country’s debt, according to a leaked version of their draft coalition agreement that emerged on Tuesday evening, something they have denied.

The draft text of the budding deal between the anti-establishment Five Star Movement and the far-right League, published yesterday by Huffington Post Italia, also called for the creation of a mechanism to exit the euro and a renegotiation of Italy’s budget contributions to the European Union, as well as an end to sanctions against Russia.

On Wednesday the League’s economic adviser Claudio Borghi appeared to walk back on the idea that the ECB should cancel Italy’s debt.

Lorenzo Codogno, chief economist at LC Macro Advisors, said the leaking of the coalition draft document was “an eye-opening experience for those who had a very complacent attitude towards a 5SM-League government” and “a watershed in the external perception of what an anti-establishment government may mean”.

“The attitude of financial markets will not be the same from today onwards,” Mr Codogno said. “The onus will be on these two parties to reassure and mainstream these proposals as quickly as possible, but it may now become an uphill struggle.”

Giovanni Montalti, an analyst at UBS, said that investors’ growing jitters over Italy’s political outlook “may trigger higher volatility” in the markets.

“The market’s working assumption since the election has been that the platforms from both [parties] had already veered away from extreme solutions to shift towards more mainstream outcomes,” he said. “Any incremental element questioning investors’ assumption is likely to have a negative market impact.”

Italian equities are particularly vulnerable to political news, he added.

Jordan Rochester at Nomura said that the limited move in the euro is “reflective of a market that already has short term downside plays on given the recent move but also the market not fearing contagion risk for now”.