Traders are worried this could be the 'big unwinding' of Italian bond markets

  • On Friday, two-year Italian bond yields rose 35 basis points in one day — almost equivalent to the entire range of the year for U.S. 10-year Treasurys.
  • This was the weakest session in five years and continued a month that's seen these yields rise 70 basis points in total.
  • Ratings agencies are also beginning to raise alarm bells.

Italian bonds have witnessed one of their worst trading weeks since the euro zone sovereign debt crisis, with many traders getting a stark reminder of the volatility that once characterized markets in the region.

On Friday, two-year Italian bond yields rose 35 basis points in one day — almost equivalent to the entire range of the year for U.S. 10-year Treasurys. This was the weakest session in five years and continued a month that's seen these yields rise 70 basis points in total.

Yields move inversely to a bond's price and a spike higher is seen as investors feeling more concerned about lending to Italy's government. More specifically, traders usually sell short-maturity paper when there are growing credit risk concerns at a sovereign level.

The original catalyst for the selling came from the populist parties hoping to take control of Italy after inconclusive elections in March. Lega and the Five Star Movement (M5S) plan to issue short-term bills to finance state activity in their economic policy proposals. Market participants were taken aback and many have interpreted that initiative as laying the foundation for a potential parallel currency in the future, further amplifying the potential new government's collision course with the rest of Europe.

But the fear has not been limited to short-dated paper. Ten-year Italian bonds have also came under pressure with yields topping 2.5 percent and are now trading at their widest gap with German paper in over four years.

There is palpable anxiety in the market as Italy's political future remains uncertain. Over the weekend, M5S and Lega looked to have failed in their bid to form a government after President Sergio Mattarella rejected their pick for economy minister due to his euroskeptic credentials. This has raised the prospect of a caretaker government to lead the country into yet another round of elections later this year.

In Monday's trading session, and with liquidity in markets thin due to the U.S. Memorial Day, Italian two-year yields briefly snapped back 15 basis points tighter before paring all the gains of the day. Traders have pointed to short covering in the market.

However, the relief rally may be short lived. One head of trading at a large fund manager, who preferred to remain anonymous due to the sensitive nature of the situation, told CNBC that a "big unwinding" is beginning for Italian bonds and Monday's pullback would not last long.

Ratings agencies are also beginning to raise alarm bells. On Friday, Moody's hinted that it may look to review Italy's debt rating, citing concerns over the two anti-establishment parties' fiscal plans that could ratchet up spending by as much as 100 billion euros ($117 billion), according to some analysts.

With outstanding debt of more than 2.3 trillion euros and one of the highest levels of debt-to-gross domestic product in the advanced world, Italy's public finances will come under scrutiny again if spending ramps up.

Gene Frieda, a global strategist at Pimco, told CNBC via email that the immediate concern for investors is that another round of elections and the prospect of a right-wing anti-European populist government undermines the economic recovery in Italy.

"(It) threatens further rating downgrades. In that context, even after the recent sell-off, BTPs (Italian bonds) do not look particularly cheap," he said.

On Monday, Matteo Salvini, the leader of the right-wing Lega party, further added to market concerns saying that there is no point staying in the EU if the rules don't change. This has prompted some analysts to believe that if there is another election on the horizon, one that would effectively be a referendum on the euro.

According to Goldman Sachs analysis, 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.

The question is then, will investors still want to own that risk into what could be a binary event?

—CNBC's Annette Weisbach contributed to this article.