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Italy's crisis could lead to 3 different scenarios for its volatile bond market

Key Points
  • The spread between Italian and German bonds could fall below 200 basis points in case of a MS-PD coalition, an analyst told CNBC. 
  • However, there are other possible scenarios. Mattarella could appoint a technocrat leader for the time being and call snap elections for 2020; or call a new vote for as soon as possible.
Deputy Prime Minister and Labour Minister Luigi di Maio(L), Italian Prime Minister Giuseppe Conte(2L), Italian deputy Prime Minister and Interior Minister Matteo Salvini(2R) and Italian Economy and Finances Minister Giovanni Tria(R) hold a press conference on the Italian budget on October 15, 2018 in Rome, Italy.
Antonio Masiello | Getty Images News | Getty Images

Italy's fresh political crisis has left investors contemplating how to trade its sovereign bond market which has seen significant volatility over the last few months.

"(It's) close to impossible to make political predictions. The situation is very unusual, (there's) no precedent," Francesco Papadia, a senior fellow at the think tank Bruegel and former official at the Bank of Italy, told CNBC's "Squawk Box Europe" Wednesday.

Rome's two-party coalition came to an abrupt end Tuesday after Prime Minister Giuseppe Conte resigned from his post following pressure from the right-wing Lega party. President Sergio Mattarella will hold consultations with various parties in Parliament in the coming days to see whether there is a working majority which would avoid the need for fresh elections.

Amid the uncertainty, Florian Hense, an economist at Berenberg bank, has detailed how bond markets could react to certain political developments. His predictions track would could happen to the gap between the yields on Italian and German government debt. This spread known as a "fear gauge" by European investors and specifically looks at the difference between 10-year yields on these fixed-income assets. The spread was at 209 basis points in early afternoon trade Wednesday, compared to 330 basis points in November.

M5S-PD coalition

Rome's coalition was made up of Lega and the anti-establishment Five Star Movement (M5S). But there is now speculation that M5S and opposition party Partido Democratico (PD) could join forces against Lega.

The spread between Italian and German bonds could fall below 200 basis points in this scenario, Hense told CNBC. He explained that M5S and PD could compromise to put together Italy's 2020 budget, due in mid-October, that respects the EU's fiscal rules. This would mean that investors would see fewer risks when purchasing Italian debt.

The prospect of a populist win would lead to a bumpy ride for Italian assets.
Matteo Ramenghi
Chief investment officer UBS wealth management

Italy's spending plans have been in the spotlight since the Lega-M5S coalition came to power in 2018. Both parties wanted to increase spending and confronted the European Union and its fiscal rules on different occasions — which caused yields on Italian debt to spike.

Matteo Ramenghi, chief investment officer UBS global wealth management, said in an email: "A M5S-PD coalition would likely introduce more fiscal discipline, but its lifespan would probably be short."

Technocrat government

However, there are other possible scenarios. Mattarella could appoint a technocrat leader for the time being and call snap elections for 2020.

Hense predicted that in this instance, the spread could fall below 200 points, as a technocrat government would work to follow the EU's fiscal rules. These state that a euro zone country should not have a deficit higher than 3% of its annual output and a public debt higher than 60% of its annual output.

Snap elections

However, Mattarella could decide that there is no other alternative but to have a new vote before the end of the year.

Hense said this outcome would lead to an increase in the spread to 250 to 300 basis points.

"Conversely, should elections take place, a win by the center-right might prove more market friendly than the current government, but the prospect of a populist win would lead to a bumpy ride for Italian assets," Ramenghi, from UBS also said via email.

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Italian Prime Minister Conte has resigned