Lastly, the political backdrop adds to investors' worries. Since Draghi entered the political scene, it has been a smooth ride. However, now that president Mattarella is to leave the Quirinale in January, political parties are trying to push the former head of the ECB to take this role. That would be a gamechanger for Italian politics because the President will need to appoint a new technical government or call an early election. The problem with this notion is that Draghi is an essential figure when it comes to the country’s relationship with the EU. The Italian economic recovery depends on European financing. With Draghi, Italy has the certainty that the money of the NextGenertionEU fund will be spent according to plans and that the necessary reforms will be implemented. This way, Europe will continue to finance the recovery. Without Draghi, the country faces the risk of a fractured political system, risking that anti-European parties will come at play again, threatening the country’s international credibility.
By focusing on the omicron outbreak, the market is underplaying this political risk, which may play out in just a few weeks.
Italian yield curve: bear-flatter first to bear-steepen later.
The above means that Italian yields are poised to rise, and the BTP-Bund spread to widen. While covid distortions will continue to keep yields in check, they will accelerate their rise once this cap is removed.
We expect to see Italian yields higher across the curve in the upcoming months. However, the most imminent risk is for the front part of the yield curve to spike if the ECB doesn’t tread carefully its message surrounding the ECB. In the meantime, the long part of the yield curve will remain in check amid a new wave of covid.
In case of political turmoil, long-term yields will rise despite covid news. Yet, if Draghi remains as premier, it's likely we won't see yields soaring until fears concerning covid are eased. Yet, as a new wave of Covid comes to an end with the PEPP program, it will be unavoidable to see the long part of the yield curve adjusting higher with 10-year yields rising to 1.3%.
As a consequence, we'll see the BTPS-Bund spread widening, although at a slower pace. Higher BTPS will be accompanied by higher Bund yields touching a maximum of 150bps before resuming its long-trend tightening. Indeed, we remain constructive BTPS in the long term as we see the new German government working towards better European integration.