Watch Italy

The domestic machinations in Slovakia will soon be resolved and passage of the EFSF reforms remains the high probability scenario. The bigger political risk may lay with Italy today.

After losing a vote that seemed largely a formality yesterday (approving last year's government balance sheet), Prime Minister Berlusconi is under pressure to hold a vote of confidence. There are press reports suggesting a vote of confidence could be held as early as today following President Napolitano's call on the Prime Minister to prove that he still has a governing majority. Yesterday's vote, a draw, could have been resolved if coalition partner Northern League head Bossi or Finance Minister Tremonti had been present. The fact that they were not has given rise to speculation of a "palace coup" of sorts.

The Prime Minister and Finance Minister have been feuding for several months at least. Most recently they fought over the austerity package and their fighting appears to be delaying the appointment of Draghi's successor as the central bank governor as Draghi moves over to the helm of the ECB.

Berlusconi is pushing for the director general of the Bank of Italy to replace Draghi while Tremonti want the director general from the Treasury Dept. Separately, Bini Smaghi on the ECB board is willing to step aside to make room for some one from France (thought nationalities are said not to matter), if he is given another suitable position. Bini Smaghi might make a good compromise choice for BoI head.

Also absent from yesterday's vote was the former Industry Minister Scajola, who has a little more than a dozen allies that are reportedly also considering breaking from the Prime Minister. Berlusconi faces 4 criminal trials and has come under increasing political pressure to resign. Earlier this month an ad in a newspaper that Berlusconi does not own, taken out by the employer's association, called for the PM's resignation. The relationship between Italy's politics and economics is a hotly debated point.

When Moody's and S&P downgraded Italy recently (Oct 4 and Sept 19 respectively) they cited political instability (as well as rising borrowing costs). Finance Minister Tremonti has suggested Spanish debt has outperformed Italian debt since its PM called for early elections.

The problems Italy faces may have deeper roots than simply the current prime minister. It is not clear that the opposition offers a significantly different agenda rather than different personalities.

ECB bond buying of Italian debt began in early August and pushed 10-year yields sharply lower, but only for about two weeks. The 10-year yield has risen steadily since dipping below 5% and today is near 5.75%, with a few basis points of its highest since ECB action began. Italy is planning to sell bonds tomorrow. Italy has a heavy supply schedule over the next several months. On the other hand, Italy's 5-year CDS prices hit their lowest level (~409 bp) yesterday since early Sept. The risk is on the upside.

If Berlusconi fails to win support in the confidence vote, there is likely to be an attempt to avoid elections. This could be achieved by Berlusconi trying to put together a new coalition. Failing this a different prime minister could be selected if a new government could have a majority in the existing parliament. Some suggest former Justice Minister Alfano as a possible candidate.

Alternatively, a technocrat government could be cobbled together and would have a very specific mandate, such a 2012 budget issues. Here there has been some suggestion as former EC Commissioner Monti. Only if these three options fail will the new election be called.