Why the Italian vote failed to shock markets

Althea Spinozzi

Fixed Income Specialist, Saxo Bank Group
Althea Spinozzi joined Saxo in 2017, and serves as Fixed Income specialist. Althea produces Fixed Income research and works directly with clients in order to help them select and trade bonds. Because of her background in leveraged debt, she is particularly focused on high yield and corporate bonds with attractive risk and return.

Last weekend, while many took the opportunity to spend some hygge time with a cup of hot chocolate in front of the TV, Italians headed out to the polls. Elections in Italy are social events: people go to the nearest piazza, sit down at one of the many small cafes, and have an espresso while reading the newspaper. 

Once they are finished with their coffee they slowly walk towards their polling place, stopping frequently to salute friends and comment on the elections. During the walk from the coffee place to the polling place, an Italian may change her mind countless times, but she knows that the moment of truth will come once the pencil is in her hand and she decides in a final sense who to vote for.

That moment is a glorious one for anyone who believes in democracy and wants to contribute to the future of their country. With the March 4 vote, however, it is hard to define the connection between the ballot and Italy's future; all that seems clear is that more political chaos is to come.

The populist Five Star movement gained the largest number of votes (32.67%) while the right-wing coalition composed of Lega Nord, Forza Italia, and other two smaller parties took a majority of votes, potentially enabling them to form a government (37%).  

The clear loser is the Democratic Party lead by Renzi, which took less than 20% of the votes, pushing the erstwhile leader to an unavoidable political suicide and forcing him to resign as leader of the governing centre-left party.

It is clear that the ballot totals do not make for any clear and untroubled coalitions, meaning that the longevity of the next Italian government could well be limited.

One might assume that the chaos created by the Italian elections could have provoked a selloff in the broader market, but the only real signs of weakness were those coming directly from Italy. While BTP 10-year futures fell by 101 ticks at Monday morning's market open, the yield of the benchmark 10-year BTPs rose by just seven basis points, touching 2.02% before retreating during the day and closing at 1.99%. 

The Italy/Germany 10-year bond spread widened slightly on Monday reaching 135 bps, a level that remains well below the 160 bps seen at the beginning of the year. 

Surprisingly enough, peripheral bonds actually rose with yields falling by approximately 5 bps across the board. Normally, the performance of the periphery is correlated to the countries belonging to this group. On Monday, however, this was not the case meaning that investors aren’t seeing a contagion threat from Italian political instability.

Although the Italian election was a non-event, the market's reaction should make us think hard about the European bond market situation and what it means for those trading in this space.

First of all, we have to recognise that volatility is dead. The killer? The European Central Bank. Not long ago, the ECB said that it is not in hurry to taper and hike interest rates, making it clear that it will not compromise the good work done until today. The reaction of the market during the Italian elections meant that while the ECB will meet to review monetary policy on March 8, investors believe that there will be no real hawkish talk.

In fact, as soon as the ECB does tighten its monetary policy, the BTP will be the first sovereign in the eurozone to be put at risk.

Another thing to consider is that maybe populism has become the norm. Italy is not the first European country to show sympathy for populist parties, making their victory an expected event. In addition, even the populist parties have to face the fact that the result of the election is a hung parliament, meaning that it is necessary to find an agreement with other parties in order to govern. 

This is an important point because it implies that parties have to soften their stances in order to be able to successfully govern (with a short-lived government the alternative). This doesn’t necessarily represent a great risk for investors; in fact it actually confirms that large elements of the Italian status quo will remain in place for longer than the result might immediately suggest, with the populists' nationalist plans rendered unenforceable.

Although the ECB is watching our back, it is wise to expect Italian BTPs to slide in the next few months. From the beginning of quantitative easing in March 2013 until today, the average yield of the 10-year BTPs has been 2.387%. It would be unlikely to see Italian sovereigns break this level, but an increase of 25/30 bps (that would see 10-year BTPs at 2.30%) might be possible, especially if sovereigns are going to be under pressure for longer in the event of a populist party leading the government. 

An increase of 30 bps might not seem much given recent events, but we must keep in mind that while foreign investors may sell or stay on the sidelines, domestic real money is the biggest buyer and supporter of the Italian bond curve, which means that as soon as they see signs of weakness, they will buy more sovereigns in order to take advantage of rising yields.

In short, Italian populism will not drag Europe under.

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