Listen, the good news for Italian bonds is that having a functioning government and demonstrating a healthy respect for fiscal rectitude are no longer prerequisites when it comes to whether the market is willing to give you the benefit of the doubt.
Just ask the U.S., where “gridlock” has become the defining feature of the American political landscape and where, despite controlling the entire government, the only thing the GOP has managed to “accomplish” over the past year is ramming through a deficit-funded tax cut that, if the IMF’s projections are borne out, will help put the U.S. in worse fiscal shape than, ironically, Italy by 2023.
Despite that rather “deplorable” (pardon the pun) situation, 10Y Treasury yields are still having a hard time sustaining a push above 3%.
Of course the reason BTPs and other periphery debt became something of a “safe haven” earlier this year amid the intermittent market turmoil was in part attributable to the implicit ECB guarantee illustrated rather poignantly in the following chart from Citi:
Similarly, the reason a growing percentage of Italian junk bonds were trading inside of U.S. Treasurys last year was of course in part attributable to the effects of CSPP (i.e., driving credit investors down the quality ladder in search of yield):
But the fact that Draghi is to thank (or “to blame” depending on your penchant for decrying central bank distortions) didn’t make it any less amusing to watch as the BTP-bund spread continued to grind tighter even as risk-off was the prevailing market mode in February and late March.
That’s started to turn around of late as the ongoing political jockeying in the wake of the inconclusive March elections continues to suggest that a populist government in Italy is the most likely scenario. Italy was back in the spotlight earlier this week when it began to look like snap elections in July were in the cards and that possibility led to a selloff in Italian bonds and also in Italian equities. The BTP-bund spread began to widen.
Fast forward to Wednesday and Berlusconi dropped his opposition to a Five Star Movement-League alliance, increasing the chances of an outright populist government. Basically, it’s either that, or snap elections. Both of which bode ill for Italian assets, at least in the near-term and the Draghi “put” notwithstanding. And so, the BTP-bund spread has now blown back out to its widest since March, up 14bp over the past three days:
“Should an agreement be reached between the Five Star Movement and the League, we would expect 10-year BTP-Bund spreads to shift higher and up to one standard deviation (30bp) above ‘fair value’ estimates on the short-term (towards 145-150bp), in line with the historical swings captured by our model,” Goldman wrote, in a note dated Wednesday, before adding that “such a move on BTPs could partly spillover towards other EMU peripheral markets, but it should not trigger an escalation of systemic risk, at least until markets have more clarity on the new executive and its composition [although] the sell-off could extend should the more Euro-sceptic factions within the two parties take the lead.”
For what it’s worth, here are Goldman’s “fair value” estimates:
Perhaps former trader turned Bloomberg columnist Richard Breslow put it best on Thursday morning when he noted that Draghi will simply “rip the eyes out of” anyone who dares to challenge his printing press’s power when it comes to suppressing periphery spreads and preventing the market from assigning a political risk premium. To wit:
The Italians are as close as ever to getting a properly populist government. One that was described for months as a disastrous possibility for the country and Europe as a whole. Reaction? A modest widening of 10-year BTP spreads to bunds. It’s difficult to even pretend the move has been dramatic, because it has gone to levels not even close to where they flew to when traders thought there was a remote chance this could happen. Why? Because there is a blanket assumption that the ECB stands ready to rip the eyes out of anyone who causes too much trouble with their shorts.