Prospect of Italian Election Crushes Italian Bonds

News that an agreement has been struck that will allow for national elections in Italy in March spurred a large rise in Italian bonds, and likely signals the underperformance of Italian assets.  

Reports suggests that Italy's president likely dissolve parliament in the last week of December in preparation of elections that will be held in early March.  March 4 seems to be the favored date, but March 11 is also possible.   Elections need to be held by May 20.    In recent weeks, speculation of this has mounted as the prerequisite preparation of the new laws and electoral college have been agreed by the relevant bodies.  The leading political parties also apparently have reached an agreement.  

Polls suggest a very close race between the three main political forces.  The center-right, led by Berlusconi, has a slight lead in the polls, followed by the Five Star Movement, with the governing PD in a close third place.  However, no party or block is drawing more than 40% of the vote, and this warns that perhaps the new electoral law has not gone far enough to ensure a more stable government.  Recall that Italy has had five different prime ministers with the same parliament.  

The most likely scenario is that no party garners a majority of parliament seats.  Rather than a hung parliament as the British press may call it, the results likely point to a broad coalition government.  The Five Star Movement continues to rule out forming a coalition with any other party, as the party's fundos-wing still seems to be in charge nationally, while local electoral victories have been led by the realos wing.  This means that the next government will likely be a center-right coalition with the center left.  

Italian 10-year bond yields have shot up 8 bp on the news today.  Domestic investors may not have been as surprised as some foreign investors.  Italian bonds had been among the best performers in the EMU over the past month and today's losses make them among the worst.   The premium Italy pays over Germany fell to the low of the year at the end of last week (~1.34%) and now it stands near 1.46%, the most since mid-November. The peak for the year was set in April near 2.13%. 

A further increase of the Italian premium, which means the underperformance of Italian bonds is likely in the coming period.   The 100-day moving average is near 1.57% and congestion from the summer extends toward 1.75%.   However, for some investors, the alternative to Italian bonds is not Germany but Spain.  Italy's premium over Spain had narrowed to less than 23 bp yesterday, the lest for the year.  

Catalonia holds its election on December 21 as it will choose a new government after the push for secession by the former government failed.  The Italian premium over Spain has widened to a little more than 29 bp now.   We expect the next Catalan government will be less confrontational, rebuild confidence in the local economy, while reaching out to Madrid and the EU.  The Italian premium could widen to 40-50 bp in the coming weeks.  

Contagion from the government bond sell-off has spurred investors to downgrade Italian bank shares.  Specifically, an index of Italian bank shares is off 2.45% today, which would be largest decline since May.   The All-Share Banks Index is up 20.4% year-to-date with today's drop.  

The cost of insurance on Italian sovereign bonds (credit default swap) recorded its low yesterday since March 2016 and is up a little more than a single basis point today.  At 1.14%, the CDS is at a four-day high.  

When this year began, many were concerned that the populist-nationalist wave that ostensibly led to the outcome of the UK referendum and the US election was going to sweep across Europe.  It did not.  Unlike in the US and UK, the center-right in most European countries ran against the populist-nationalist forces.  This seems applicable to Italy as well, where Berlusconi appears to have become increasingly critical of the Five Star Movement.  Moreover, in recent months, the Italian economy has improved.  The election announcement, though not official yet, is coming when Italian assets had rallied.  

That said, if we are right and the Italian election will not lead to a decision to leave the EU or EMU, then what may appear as the overreaction by investors may create a new buying opportunity.  In the near-term, however, Italian assets are likely to give back some the outperformance seen earlier this year.  

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