- Italy is facing higher debt costs as the ECB looks to tighten its monetary policy.
- Investors are focused on the Italian growth and fiscal outlook.
- Political fragmentation is a key concern when assessing the future of the Italian economy.
An eventual result in Italy's presidential elections may have averted political instability for now, but market watchers are wary over the economic and political future of Europe's third-largest economy.
The yield on the Italian 10-year government bond traded at 1.8680% late Tuesday afternoon — up around 5 basis points and building on the gains seen Monday. The rate on the benchmark bond is at its highest since April 2020, meaning the Italian government is now facing higher costs when raising funds from public markets — which could ultimately become an economic headache for Rome.
"The peripheral bond market needs to adjust to the reality of a world without ECB QE [quantitative easing]," Frederik Ducrozet, strategist at Pictet Wealth Management, said in a note to clients on Tuesday.
One reason for this week's moves in European debt markets is the increased expectation that the European Central Bank will tighten monetary policy during 2022, with a possible rate rise later this year. Any rate hike would be the first since 2011, when the bank was criticized for moving too early in a time of great financial stress.
The 19 nation euro zone, of which Italy is a member, has seen loose monetary policy since the sovereign debt crisis of 2011 with billions pumped into its economy to stimulate lending and boost economic activity. As the region's outlook was starting to improve in 2019, it was then hit by the coronavirus pandemic and the ECB subsequently launched a new bond-buying program.
This included purchasing even more government bonds across the euro area, so nations would face lower costs when raising new debt.
"In 2020-21, the Bank of Italy bought over 100% of net supply of Italian central government debt. In 2022, we estimate that the central bank will buy up to 60% of net issuance. In 2023, this source of demand will be gone," Ducrozet said, highlighting the changing landscape for monetary policy.
As a result, he added: "The growth and fiscal outlook will be key" for Italy.
An additional problem for Italy is its parliament, which often experiences huge political fragmentation, impacting its growth and fiscal outlook.
It's "clear that party heads do not have a strong control over their parties. That's what makes me nervous," Gilles Moec, group chief economist at AXA Investment Managers, told CNBC Monday.
Indeed, political fragmentation is so acute right now that lawmakers recently took eight attempts to elect a new president. After nearly a week of inconclusive voting, lawmakers decided to ask Sergio Mattarella to continue as the country's president — despite him wanting to leave the job.
"The duo Mattarella-Draghi may provide a backstop in the short run, but Italy's prospects in the medium-long term remain highly uncertain," Wolfango Piccoli, co-president of the consultancy firm Teneo, said in a note to clients last week.
Mario Draghi, who has been serving as the country's prime minister for a year, has brought stability to the nation. He has put together a plan on how to invest almost 200 billion euros ($228.6 billion) of European pandemic recovery funds while keeping the support of the main political parties.
However, Draghi's mandate comes to an end in the spring of 2023 — when new parliamentary elections are due.
There's now key questions on whether Draghi, a former ECB president, will manage to keep implementing much-needed reforms before the end of his mandate. Political parties will soon start to lay the ground for their election campaigns and, more broadly, an election will undoubtedly bring uncertainty on what sort of coalition will emerge after the vote.
"While a stronger leadership by Draghi is a necessary condition to keep the demons of Italian politics under control, it is not sufficient to keep the country on track over time," Piccoli said.
Opinion polls project a very divided Parliament in Rome in the wake of next year's election. The center-left party Partito Democratico and the far-right Fratelli d'Italia have the same backing in current polls, at around 21%. The anti-immigration Lega party follows with 18% of the votes, and the left-leaning Five Star Movement stands in fourth with about 14% of the support. This is according to data collected by Politico.
This suggests the next election will be a very tight race and there are different coalition formats are possible. Investors will be interested to know what are the chances that Rome keeps implementing the necessary economic reforms to receive the massive European recovery funds, which will be critical to boost the Italian economy.
"Markets will be very vigilant of that," Gilles Moec from AXA Investment Managers said.
However, it is unclear the level of commitment by some of the parties to implement the reforms that Draghi agreed to with the EU.
"Well, I don't see why (Italy's economy should be at risk)," Francesco Lollobrigida, Parliamentary Leader for Brothers of Italy told CNBC in Rome, when asked if his party understood the economic risks of not reforming.
"Italy is not a country that the EU can do without. A strong Italy is also useful for a strong Europe. So the two things must happen in parallel," he said.
Europe's massive recovery plan is highly dependent on Italy. This is because Rome is receiving the highest amount than any other EU nation within this program. Failure to reform and get those funds would question Europe's efficiency in implementing its targets.
--CNBC's Anita Riotta contributed to this article.