Italy’s political crisis and its effect on bond markets

No one ever wants to take credit for starting turbulence in the financial markets. However, this week it isn’t the US, it’s Italy.

March elections in Italy resulted without any political party gaining a clear majority in the lower house, called the Chamber of Deputies. This isn’t uncommon. In fact, in Europe, it’s normal for parties to ultimately form governments through agreements between leaders on cabinet placements, setting agenda, priorities, etc.

The problem now is that negotiations have been going on for months between various parties and the sitting President, Sergio Mattarella. A majority in the lower house did form from two parties which together have political leanings that are on one end, skeptical of the European Union and on the other end, anti-European Union. Mattarella is pro-EU and rejected the coalition nomination for Prime Minister in favor of his own appointee, a prior official with the International Monetary Fund named Carlo Cottarelli. Cottarelli has gained parliamentary approval and now the call for new elections seems less likely… Whew! Who knew all of this could send short- and long-term Italian bonds soaring to their highest levels in years in a span of 24 hours? Here’s why.

Italy is a large player among EU economies, 3rd to be exact. Further, Italy holds a large amount of public debt and has a very large population. Feuding between the president and an anti-EU political majority in the lower house about who will become the next Prime Minister can immediately destabilize a government, especially since the last elections were so recent.

Yields for Italian 2-year bonds rose the highest since 1992, and treasury 10-year bonds jumped to 3.38 percent. These market barometers, among other EU-specific measurements that broke records sent investors running from Italian bank stocks to German and US bonds. The Italian central bank then had to auction new 6-month bills at much higher interest rates which of course piles on new near-term debt maturities.

Spain, Italy’s closest EU counterpart, is fortunately weathering the changes nearly unaffected–a welcome sign considering how during the last financial crisis, the economies of both countries plummeted together. With Greece, southern Europe was collectively to blame for dragging down the EURO with it.

Rest assured, the European Central Bank, European Commission are watching closely at how the present situation unfolds. The best scenario for the Italians and their financial markets would be for the political landscape to come into focus on its own, to form a government, without new elections being called this summer. The latter is unlikely but not guaranteed, and fund managers, and sovereign credit analysts will be watching closely. Yahoo!Finance NYTimes Upshot Business Insider

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