(Bloomberg) -- Italian bond spreads could blow out to levels not seen in five years should a euroskeptic alliance come to power.
Though analysts are only assigning a 10 percent chance to the possibility of such a coalition dominated by the Five Star Movement taking office, the prospect may pose a sleepless night on Sunday for traders who are long the nation's debt. In this scenario, median estimates of analysts in a Bloomberg survey see the 10-year yield premium over German bunds doubling to 260 basis points, a level not seen since 2013, and the euro sliding below $1.21.
The odds of former Premier Silvio Berlusconi playing a role in government are seen as favorable, just seven years after he was forced to resign amid the sovereign-debt crisis. A slim grand coalition between his Forza Italia and Matteo Renzi's Democratic Party could narrow the bond spread to 118 basis points, while a center-right pact with the Northern League could be the best-case scenario for euro and may boost it toward $1.24 from around $1.22 currently, the survey shows.
A victory for Five Star would be “euro-negative and see BTP-bund spreads widen as this is likely to deliver a candidate that may want to push for a euro-area exit,” said Matthew Cairns, a strategist in London at Rabobank International. “Still, the chances of such a coalition being formed remain slim, at best, in our view.”
The most recent polls published before a blackout period that began on Feb. 17 showed a hung parliament as the most likely scenario, with the Five Star Movement as the largest party and a center-right coalition led by Berlusconi close but short of a majority. The Italian 10-year bond spread over Germany has dropped around 25 basis points this year to 134, a sign that few investors are overly concerned by the prospect of a euroskeptic victory.
Here is a breakdown of how analysts expect currency and bond markets to react to the election result:
Italian Bonds
- The 10-year BTP/bund yield spread is close to fairly priced, with asymmetric risk-reward of very small probability of large widening and decent probability of modest tightening, says JPMorgan strategists led by Fabio Bassi
- Puts a 3% probability of a “non-mainstream” government, with yields widening out to 300bps; best case is a slim grand coalition with 31% chance, narrowing spread to 100bps
- Credit Agricole sees spreads stabilizing in 130-150bps range, assuming a euroskeptic government does not take shape
- UniCredit's base case is a “formation of a broad coalition of mainstream, pro-European parties,” which would lead to the spread tightening to around 110bps; market is pricing in a “fairly favorable outcome” already, write strategists including Luca Cazzulani
- New elections are given a probability of 21% by Nomura, with spreads potentially widening out to 200bps
- A non-mainstream coalition majority such as one led by the Five Star Movement is the worst outcome for the euro but also the least likely one -- the consensus points to a 10% likelihood
- The euro could see a knee-jerk slide to $1.2054 under this scenario, assuming the currency is around the $1.23 mark going into the vote
- “Given the number of undecided voters in the “swing regions”, there is a risk that the Five Star could win more seats than projected, albeit not enough for an outright majority,” according to Valentin Marinov, head of Group-of-10 currency strategy at Credit Agricole SA. “Such an outcome could weigh on the euro, at least initially. At the same time, evidence that the mainstream parties held their ground could help the euro to regain some lost ground”
- The most positive outcome for the euro is predicted to be a center-right majority, which could boost it to to $1.2380 in the aftermath of the vote; the Bloomberg survey points to a 20% probability of this
- Prospects of a hung parliament stand at 40% and see the shared currency at $1.2250
- In the longer run, strategists remain sanguine about the overall impact the elections will have on the currency
- “Even though factors such as euro-skepticism and slow structural reform are more pertinent in Italy, strong euro-zone growth has provided the euro with a comfort blanket,” said Jane Foley, head of currency strategy at Rabobank
--With assistance from Hayley Warren
To contact the reporters on this story: John Ainger in London at jainger@bloomberg.net, Anooja Debnath in London at adebnath@bloomberg.net.
To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Anil Varma, Marco Bertacche
©2018 Bloomberg L.P.
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