Italian government crisis? Not a big deal…

Market reaction to Italy’s Prime Minister resignation has rather been quiet. Yesterday, Italy-Germany government bond spread was moving lower, around 200 bps, and there was no sign of contagion to other PIIGS countries. Saxo model of periphery weighted spread to Germany (which is GDP weighted) was also down, at 177 bps, close to the lowest levels reached this year.

Investors seem to believe that, in a central bank world, political risk does not matter as long as it is not linked to EZ/EU membership. On the top of that, expectations of further ECB stimulus in September, which could consist in a new QE package coupled with lower deposit rate, is also pushing down interest rates.

Conte’s resignation turns the focus to Italian President Mattarella. We think there are mostly three options to solve the ongoing political crisis:

1/ A grand coalition that could gather the PD and the M5S with potential participation of Forza Italia (this scenario, that was quite unlikely a few days ago, has been intensively discussed since yesterday). It would be the most market-friendly option and it seems to be supported by the European Commission ahead of budget discussion.

Market impact: LOW. Italy-Germany gov. bond spread around current level, at 200 bps.

2/ A caretaker government whose main objectives would be to pass 2020 budget and implement more tightening in order to be in line with the European Commission’s deficit target. At first, it looks more market-friendly than the previous option, but this government is unlikely to last long. New elections would need to take place next year. This option would be a form of “extend and pretend”.

Market impact: VERY POSITIVE (at first). Italy-Germany gov. bond spread below 200 bps.

3/ Snap elections in Q4 2019. This option implies an elevated risk that Salvini could be in a position to form a right-wing coalition, which would increase tensions with the EU and other European governments, notably France.

Market impact: NEGATIVE. Italy-Germany gov. bond spread back to 300 bps.