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James Hyerczyk

The alarm bells are ringing in Italy and it doesn’t look good for the Euro. Late last week, Italian bonds posted one of their worst trading weeks since the Euro Zone sovereign debt crisis. Volatility has returned and it’s shaking investor confidence in the region.

Two-year Italian bond yields rose 35 basis points on Friday. If you’re a bond investor then you know that this is a tremendous one day move, almost equal to the entire range of the year for U.S. 10-year Treasurys. You’re also probably aware that a steep drop in short-term maturity paper usually means there are growing credit risk concerns at a sovereign level.

With populist parties like Lega and the Five Star Movement (MFS) planning to issue short-term bills to finance state activity in their economic policy proposals, traders feel that this could be the first sign that they are planning to issue their own currency at some time in the future, or some currency that runs parallel with the Euro. This is rattling Euro investors, causing them to pare positions before things get worse.

One thing that Euro investors learned from the situation with Greece years ago was to sell Euros on the first hint of problems. In other words, don’t wait until you see the flames, sell when you smell the smoke and this may be happening in regards to Italy.

While the assault on the bond market on Friday was massive, it could be just the beginning of even stronger selling pressure. Over the week-end, Lega and M5S failed in their bid to form a government after Italian President Sergio Mattarella rejected their pick for economy minister due to his euroskeptic credentials. This will likely weaken the Italian government and push it towards another round of elections later this year.

The inability to form a viable, working government is spooking investors and encouraging them to sell Italian bonds. Some say that this is just be beginning of what could turn into a “big unwinding” for Italian bonds. Furthermore, rating agencies are also beginning to take notice of the situation in Italy. They are likely to compound the situation in Italy if they move to lower Italy’s debt rating while raising concerns over the two anti-establishment parties’ fiscal plans.

The major concern for Euro buyers is that another round of elections and the prospect of a right-wing anti-European populist government will undermine the economic recovery in Italy. This could lead to further debt rating downgrades. Additionally, the European Central Bank owns around 20 percent of outstanding Italian bonds due to years of quantitative easing, but foreign investors also own about 37 percent.

I don’t think the ECB will be selling Italian bonds to cut their losses, but I can’t say the same for the foreigners holding the risky paper asset. Experts are predicting that there is going to be another election later this year, and this will ultimately determine the fate of the relationship between Italy and the Euro.

The unwinding of Italian bonds is likely to continue because investors aren’t going to want to bet on the outcome of the elections. Furthermore, we’re likely to start hearing another phrase not heard for years. That word is contagion. This is especially important at this time because conditions in Spain seem to have also reached a boiling point.

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