Italian risk spread hits one-month high as traders assess political risk

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The premium Italy is paying on German debt hit a new one-month high on Friday as investors searched for clues about what would happen after Italian Prime Minister Mario Draghi’s resignation was rejected overnight.

Italian President Sergio Mattarella rejected the resignation and asked Draghi to address parliament to get a clearer picture of the political situation, expected next Wednesday.

On Friday, euro zone bond yields fell across the board after strong gains a day earlier, but Italian debt underperformed with yields falling below those of its peers.

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The turmoil comes at a difficult time for Italy, where borrowing costs have risen sharply as the European Central Bank (ECB) begins to tighten monetary policy.

The 10-year yield fell one basis point to 3.35% at 10:27 GMT, undoing more than half of Thursday’s rise that had pushed it as high as 3.50%.

The closely watched spread on Germany briefly widened to 229 basis points, a new one-month high, after closing Thursday at 207 basis points after a strong late-trading rally.

It then tightened to 221bps but was still well above a low of 203bps on Wednesday before politics kicked in.

“I think (the overnight developments) just leave Italy in no man’s land at the moment,” said Peter McCallum, rates strategist at Mizuho in London.

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“In my view, Draghi is going to address Parliament on Wednesday, it might imply another vote of confidence, but not necessarily. Until then, we basically have uncertainty.

“People will refrain from buying Italy in the short term. That probably pushes us further next Thursday,” McCallum added.

The risk of government collapse also comes just before the ECB gives details of its new anti-fragmentation tool to contain an “unjustified” divergence between German borrowing costs and those of highly indebted member states like Italy. at its meeting next Thursday.

“The ECB will really struggle to deploy an anti-fragmentation tool in Italy if political uncertainty widens,” said Rohan Khanna, strategist at UBS.

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“Any enthusiasm that might have arisen from a well-designed anti-fragmentation tool is short-circuited to some extent due to the surge in political uncertainty.”

If the end result is a snap election, ING analysts expect the yield spread could widen to 260 basis points.

In Germany, the 10-year rate, the benchmark for the euro zone, fell 4 basis points to 1.14%, after falling more than 10 basis points in previous transactions to 1.071%, the lowest since May 31.

Yields fell as investors cut some additional bets on ECB rate hikes this year, prices for which were priced in on Thursday.

Traders are now pricing in a 40% chance of a 50 basis point (bps) rate hike at next week’s ECB meeting and 160 bps of hikes by the end of the year, against more than 50% and 165 bps respectively on Thursday, according to Refinitiv Data. The ECB signaled a 25 basis point move for next week.

The declines follow a reduction in bets on a July 100 basis point move from the US Federal Reserve. (Reporting by Yoruk Bahceli; Editing by Kenneth Maxwell and Kim Coghill)



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