Italy spreads contagion
Negative catalysts have been few and far between in recent months, but one arrived with a vengeance this week in the form of an inconclusive Italian election.
Credit markets yesterday unwisely took early exit polls as a strong indication that a pro-reform government would be the most likely outcome. However, these polls are notoriously unreliable and hopes were soon dashed as the day drew to an end., By Tuesday morning it was clear that no party would have a majority in either house of parliament.
The reaction in the credit markets was damning. Italy's spreads widened 45bps to 290bps, the biggest daily retreat since December 2011. Italy is now trading wider than Spain for the first time in nearly a year.
From the market's point of view, Italian voters delivered the worst possible result. The possibility of a grand coalition between the centre-left Democratic Party and the centre-right group led by former Prime Minister Silvio Berlusconi appears slim. Beppe Grillo, a comedian and leader of the populist Five-Star Movement, has emerged as the kingmaker.
However, Grillo has said he will not enter into government with any of the main parties, leaving the country in limbo. Grillo might enter into a "confidence and supply" agreement and support a minority government on an ad-hoc basis, but at this stage another election seems to be the most probable scenario.
Either way, Italy looks set to have one of its familiar periods of weak government. Europe has coped with Italian political instability in the past, but these are not normal times. The ECB's Outright Monetary Transactions programme, which has underpinned the rally in sovereigns since last summer, requires countries to request a bailout before the central bank can intervene and buy bonds. If Italy's government lacks strength and legitimacy, then it is hard to see how it could seek assistance from its European partners.
This drawback in the most important component of the EU's crisis management strategy threatens to reignite contagion across the region and beyond.
Unsurprisingly, spreads were wider across the board. The Markit iTraxx Europe was 10bps wider at 120.5bps, its worst daily performance since August 2012. Italian banks and corporates were the main laggards, though Spanish and French names also suffered.
Better than expected US economic data did little to stem the tide. And while Ben Bernanke's testimony before Congress could influence spread direction, it is likely to be all about Italy this week.