Over the last week, volatility has risen sharply in the eurozone in reaction to events in Italian politics. On 21 May, the Five Star Movement and the League, the winners of Italy’s legislative elections on 4 March, struck a deal on a common platform and agreed upon Giuseppe Conti as Prime Minister.
This bid to form a government was dropped by the populist parties after Sergio Mattarella, the Italian President, blocked the nomination of an avowedly Eurosceptic finance minister. A transitional government is now being formed to steer Italy to new elections.
As a result, the risk premium (spread) between Italian and German 10-year government bonds has widened abruptly to over 260bp, its widest level since the summer of 2017.
Changes in 10-year risk premia for Italian and Spanish sovereign bonds versus German government bonds (in basis points, 2009 – 29/05/2018)
Source: Datastream, BNP Paribas Asset Management, as of 29/05/2018
At the same time, the Spanish government faces a vote of no confidence on Friday 1 June.
On the foreign exchange markets, the single currency has come under selling pressure, pushing it down below 1.16 to the US dollar, its lowest level since the summer of 2017.
Quite how such matters will evolve from here remains to be seen, but it is clear that investors are increasingly nervous. The current risk premium (spread) between 10-year sovereign bond yields in Italy and Germany is far from the level of around 525bp in late July 2012, when Mario Draghi declared the ECB was ready to do ‘whatever it takes’ to preserve the euro.
It is too early to tell how matters will play out, but we may be in for a stiff stress testing of both the risk environment and the economic environment, the latter of which remains broadly favourable despite a recent slowdown in activity.