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As investors eye France’s political, Italy’s fragility in the picture

by Isabella Bufacchi – 

A violent “risk-off” wave widened spreads all across the European government bond market yesterday: the sell off hit all govies except the German Bunds, in a typical flight to quality mood with search for safe havens focusing on highly rated short term paper.

Italy was not the trigger this time but nevertheless it was the hardest hit. In the midst of turbulence, Italy continues to be viewed as the weak ring of the euro chain: the gap between BTPs and Bund yields went through the 200 basis points threshold, back to a level not seen in the last three years. The 10-year BTP ended the day yielding a 19-month high at 2.39%.

It was a Black Monday for French paper too. France was the real political trigger: Marine Le Pen’s week-end speech, promising to call a referendum to leave the euro in case of victory, shocked the markets. French 10-yer OAT yields rose to a 17-month high, reaching 1.14%. German peers went the other way, closing at 0.37% (-0.05%). The spread between OAT and Bund yields touched a peak at 78 basis points, the widest in the last 4 years.

“There was no headline news to provoke such a move,” a French trader commented bewildered.

The markets had more than one reason to sell: they just needed an excuse to do it. Too many positions were short on German and US rates. Too much reflation trade. Too bullish on the US economy. Too long on France and Italy and the euro project in general.

The time seemed to be just ripe yesterday to close some positions, to reduce the European exposure in a year with a huge political risk. Politics is the worst risk in the markets, it is unpredictable. Polls have proven to be unpredictable. So, after the bullish mood at the beginning of the year, driven by the Trump-trade, markets are now focusing more on real facts and political risk in Europe: the Fillon saga was a reminder that things can go wrong all of a sudden, in politics, and that black swans are just around the political corner.

As for Italy, markets would like to focus on the Dutch, French and German 2017 general elections but they are forced to peer into the Italian political landscape. Italy is too big, too central, it cannot be ignored. Italy will have to raise €450 bn in gross government bond issuance this year, a heavy year for Italian historical standards and the heaviest of all in the European sovereign bond market: BTP yields are moving up by the day and Italy’s public debt refinancing cost is going up, in spite of QE and the Public Sector Purchase program by the ECB.

Yields on Italian government bonds are relatively low, compared to the scary levels of 2011 and 2012, but they are moving up, driven by the rise of political uncertainty. Markets do not like what they see in Italian politics. Italy is stuck in a vicious circle, as it keeps trying with no success to come up with a new electoral law that would guarantee the formation of a stable, solid, pro-reform, market-friendly government.

In the meantime, Italian banks have to solve the NPL problem, to free capital to inject new money into a delicate economy.

 by Isabella Bufacchi | italy24.ilsole24ore.com

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