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Italian Markets Face More Turmoil as Political Crisis Rattles On

(Bloomberg) -- Italian markets are set for more turbulence in the coming week as a political crisis deepens just as the European Central Bank gets ready to hike borrowing costs for the first time in a decade.

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The country’s stocks recovered some ground Friday and bonds stabilized as Mario Draghi remains Prime Minister for now, after President Sergio Mattarella rejected his resignation. The prospect of Draghi’s exit and snap elections hammered the country’s assets Thursday and both markets are set to be the region’s worst performers this week.

“Even if the worst-case scenario of early elections is avoided, this crisis shows that political instability remains very much a structural feature of the Italian institutional landscape,” said Silvia Merler, head of ESG and policy research at Algebris Investments. It “may result in some repricing of country risk on the expectation that the Draghi government may be challenged again.”

More volatility is likely as Draghi has to forge difficult compromises in coming days with the populists in his government to avoid the collapse of the coalition. Any sign the former ECB chief will exit would rattle markets relying on his desire to reform the economy, rein in inflation and avoid a budget blowout in one of the region’s most indebted countries.

That’s a headache coming just as the ECB plans to lift interest rates next Thursday, with markets expecting more than 150 basis points of rate hikes this year. It’s keeping the cost of insuring against default elevated for banks such as UniCredit SpA and Intesa Sanpaolo SpA, while Italy’s bond yield premium over Germany -- a gauge of risk -- is at a one-month high.

Here’s what market participants say on the outlook for Italian assets:

Seek Inflation Protection

“Tensions and uncertainties on the political front entail downside risks on the growth and financial front,” Domenico Ghilotti, analyst at Equita, wrote in a note. “In this scenario, we believe that stocks with greater international diversification and a solid financial structure (DiaSorin, Moncler, Campari, Reply), with inflation protection (Inwit, Terna, Enav) are to be preferred, while financial and cyclical stocks are the most exposed to the downside.”

Bond Danger

“The 10-year spread is now well above 200 basis points again, i.e. in the ‘danger zone’ of 200-250 basis points that has prompted verbal interventions from the ECB in the past,” said Antoine Bouvet, senior rates strategist at ING Groep NV.

“We suggest positioning for increased political risk premium by selling five-year Italian bonds versus French bonds (beta-weighted) at close to the tightest level in a year as the front-end likely continues to underperform on the curve on higher credit risk,” said Andrea Appeddu, a rates strategist at Citigroup Inc.

Snap Elections

“Elections would likely deliver a government with a strong right-wing component, which may be inclined to take a more confrontational stance vis-à-vis Brussels. Italian bond yields would likely react significantly to such a scenario, and it would be difficult for the ECB to deploy any spread compression tool that would not come with strong conditionality attached,” said Silvia Merler, head of ESG and policy research at Algebris Investments.

The ECB’s Dilemma

“With the Italian crisis, we are almost certain that there is little-to-no chance the ECB hikes rates by more than 25 basis points,” Ipek Ozkardeskaya, senior analyst at Swissquote, said in written comments. “The euro zone is too fragile, both from economic and political perspectives, to allow the ECB to take a more significant step.”

Rising Bank Debt

“Volatile bond markets could raise funding costs for Italian banks, and potentially hamper bond issuance activity,” according to Scope research analyst Alessandro Boratti, who notes that seven major Italian banks held about 115 billion euros of Italian sovereign debt in addition to around 102 billion euros in state-backed loans at the beginning of the year.

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