Mario Monti's announcement that he will step down as Italy's Prime Minister represents a significant setback in the euro zone's rehabilitation, analysts warned on Monday, with the decision set to push up Italian bond yields and heap pressure on the euro as well as push Spain closer to the edge of a funding crisis.
Monti's decision to resign before the end of the year came after former prime minister Silvio Berlusconi's People of Liberty Party (PDL) withdrew its support for the government. Berlusconi confirmed on Saturday that he would lead the party into new elections in early 2013. Hailed as Italy's savior when he took over from Berlusconi in November 2011, "Super Mario" was embraced by more austerity-minded northern European partners.
Analysts are concerned that the euro zone crisis could flare up again as investors fret over a lack of clear leadership and commitment to economic reform in Italy. If the widely-praised reforms started by Monti stall, they warn, Italy might struggle to access funding provided by the European Central Bank (ECB) and other partners.
"We believe that, should the elections yield a fragmented government majority with limited capacity to act and deliver important reforms, the ECB would not be willing to support Italy, even in the context of significant market pressure. In this circumstance, the risk of a standoff between the ECB and Italy are non-negligible and markets would likely reassess Italian sovereign risk by assigning a higher credit risk to the sovereign,"Nomura economists said in a note to clients on Monday.
In addition, some economists warn that investors have grown too complacent about Italy in recent months, arguing that a correction is due. Despite the jump in yields on Italian 10-year paper on Monday morning, the yield is still on a par with lows reached during the January-March rally that was fueled by the ECB's provision of cheap 3-year loans to banks.
"The markets have been far too complacent about Italy of late. The signaling effect of the ECB's bond-buying program has led to a period of deceptive calm in Spanish and Italian debt markets," Nicolas Spiro,Managing Director of Spiro Sovereign Strategy said.
Shares were down across Europe and Italian bond prices fellon Monday. The cost of insuring Italian debt against default rose "The 'Berlusconi effect' is palpable and is leading to a reassessment of Italian credit risk that in any case was overdue," Spiro said.
Spain will be the first to suffer from the contagion effects of turmoil in Italy. The spread between German and Spanish bonds rose on Monday and Spanish Economy Minister Luis de Guindos warned that the developments in Italy would inevitably hit Spain.
"More widely, if markets do become unsettled over Italy we may see contagion into other euro zone economies, perhaps particularly Spain which has tended to move in tandem with Italy since August 2011," Nomura's Senior Political Analyst Alastair Newton said.
He pointed out that Spain faces a heavy year ofdebt refinancing in 2013, starting in January, against a backdrop of continuing uncertainty over whether Prime Minister Mariano Rajoy will seek a bailout or not.
With elections on the horizon in Germany, the taskof calming bond markets will be left largely up to the ECB, Newton warned.
The euro, already battered by the biggest one-day loss in a month on Thurday after the ECB slashed its growth estimates for the euro zone, will also feel the effects of political instability in Italy.
"The added political uncertainty is unwelcome news, and we expect it to add further downward pressure to the euro in coming months in the form of an increase in euro risk premium," analysts at Barclays said.
Jens Nordvig at Nomura also said the developments were "clearly negative" for the single currency. The bank expects the euro to trade in a range of between $1.25 and $1.30, but expects the euro to break that range to the downside next year.
December 2012 Not December 2011
Despite the heightened sense of alert, anlaysts were also quick to point out that Monday's sell-off was a knee-jerk reaction. Recent opinion polls show Berlusconi losing support and the most likely outcome is a center-left coalition led by Pier Luigi Bersani, the leader of the Democratic Party.
Bersani will likely stick with the austerity drive, Ignazio Marino, Senotor for Bersani's PD party told CNBC.
"I think Mr Bersani will keep going on the route that Monti started, adding that Berlusconi stood little chance in the election. "Italians are smarter than that, they know that the crisis is very deep," he said.
And while Spanish and Italian 10-year bond yieldsrose, they were trading at just only just over 5 percent and 4.8 percent respectively.
"Two-year Italian yields are currently trading at 2.3 percent, still significantly below the 5 percent level before Mr Draghi's intervention and nowhere near the 8 percent level in late November 2011," Spiro said. "December 2012 is not December 2011."