Italian spread rises to one-month high as government faces collapse

Italian government bond yields jumped on Thursday driving the premium they offer over German debt to its highest in a month after a parliamentary confidence vote that could trigger the collapse of Prime Minister Mario Draghi’s coalition.

The 5-Star Movement, one of the coalition members, did not take part in the vote.

Within minutes of the vote, Draghi headed to the Quirinale Palace in Rome to meet President Sergio Mattarella, the supreme arbiter in Italian politics, who will have to decide how to resolve the crisis, a government source said.

Italy’s benchmark 10-year yield jumped by 19 basis points (bps) its biggest daily rise since June 13. It hit its highest in two weeks at 3.502%.

Italian debt underperformed peers, with Germany’s benchmark 10-year yield rising 4 bps by 1515 GMT.

The closely watched Italian/German 10-year yield spread widened to 222 bps, the most in a month, up from 208 basis points at Wednesday’s close.

“The market is not taking it particularly well but it’s been remarkably restrained,” said Richard McGuire, head of rates strategy at Rabobank. “One would argue it’s still restrained given the implications being a possible government collapse, which would be a key negative in terms of fiscal risk.”

“I think the near-term path of least resistance is Draghi’s government does muddle through but tensions rise and individual parties look to the elections next year,” McGuire added. “So legislative efficiency is going to suffer, but the market doesn’t care about that.”

The vote comes at a challenging time for Italy, where borrowing costs have risen sharply as the European Central Bank starts tightening its policy.

McGuire said spreads would have been wider had it not been difficult for investors to short Italian bonds ahead of next week’s ECB meeting, where policymakers are expected to reveal details of a new tool to contain an “unwarranted” divergence between German borrowing costs and those of highly indebted member states like Italy.

Debt analysts also questioned what political volatility in Rome would mean for the tool, which is expected to impose some degree of conditionality on states to support their debt.

“Political opposition to that fragmentation tool is already relatively elevated in some corners of Europe. If they were to invent that at the moment that the government is collapsing, that makes the whole situation a lot more difficult for (the ECB),” said Antoine Bouvet, senior rates strategist at ING.

Germany’s 2-year yield rose 8 bps to 0.53%, after hitting its highest since July 4 at 0.637%, as traders ramped up their bets on ECB rate hikes after Wednesday’s U.S. inflation print raised the odds of a full percentage point by the Federal Reserve at the end of July.

Fed governor Christopher Waller said late on Thursday he supports another 75-bps rate increase.

While the ECB has signaled a 25 bps hike, traders upped their bets on a 50 bps hike at next week’s policy meeting to more than a 50% chance, Refinitiv data showed.

They then expect around 165 bps of hikes by December, compared to 137 bps on Tuesday, and a peak rate of roughly 1.5% reached in late 2023, up from 1.3% on Tuesday, the data showed.

The three-month Euribor interbank borrowing rate was above 0% for the first time since 2015.

(Reporting by Yoruk Bahceli; Additional reporting by Stefano Rebaudo, Sujata Rao; Editing by Alison Williams)