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Italian Markets Slide as Mario Draghi’s Government on the Brink

(Bloomberg) -- Investors are dumping Italian assets as political turmoil puts Prime Minister Mario Draghi’s government at risk of collapse and complicates efforts by the European Central Bank to support the market.

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Italy’s stocks and bank debt led regional losses, while the yield on 10-year government bonds surged to increase the gap with German rates -- a gauge of risk -- to the most in a month. Traders will now be watching if Draghi resigns Thursday after his coalition partner said it would boycott a confidence vote the government called.

The latest drama comes at a testing time for bondholders and policy makers alike. A rapid debt selloff last month saw the ECB pledge a new tool to stymie any unjustified rise in yields, and the risk now is it will be harder for officials to make bold commitments that could be interpreted as more about domestic politics than monetary policy.

“Italian bonds are opening wider this morning ahead of a senate vote that could split the current coalition, lead to the resignation of PM Draghi, and to snap elections in the autumn,” said Antoine Bouvet, a strategist at ING Groep NV. “It’s fair to say that a political crisis would come at the worst possible time for the ECB as it has to attach some sort of conditionality to its fragmentation instrument.”

It’s the latest problem investors have to assess, adding to surging inflation, rate hikes and recession fears. Italian bonds have already been under pressure for months from the withdrawal of the ECB’s ultra-accommodative policies.

The ECB is expected to announce its first interest-rate hike in a decade next week as it looks to end years of negative rates in the region. The difficulty is to do so while keeping government bond markets orderly, given higher borrowing costs will hit more indebted nations such as Italy harder.

“Italian politics pulls the rug under the ECB,” said Davide Oneglia, director of European and global macro research at TS Lombard. “The ‘anti-fragmentation’ tool was always going to stand on shaky foundation and relatively quiet Italian politics was a prerequisite for it to work. Some market panic seems in order.”

Ten-year bond yields climbed as much as 24 basis points to 3.39%, while Italy’s FTSE MIB stock index dropped 2.4%. Banking shares were among the biggest losers, with Intesa Sanpaolo SpA down 3.8%, Banco BPM SpA sinking 4.6% and UniCredit SpA falling 3.5%. Bank bonds also led declines in a Bloomberg pan-European high-yield index.

The pressure on sectors closely linked to the state is building. The cost to insure senior and subordinated debt by major lenders such as UniCredit and Intesa Sanpaolo jumped the most in a month on Thursday, based on data compiled by Bloomberg.

Still, some analysts see the risk of an early election as being contained for now. President Sergio Mattarella could ask former ECB chief Draghi -- who investors have backed since his appointment early last year -- to have a round of talks with parties in his alliance to verify whether he still has their support.

“Our base case remains that the current crisis should not result in early elections as no party, including M5S, would want to go to polls when the country is facing a cost-of-living and energy crisis,” said Mohit Kumar, a strategist at Jefferies International.

(Updates with credit markets.)

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