Italian referendum: the market focus is starting to switch

After the unexpected rise of Donald Trump as US president-elect, financial markets are starting to switch attention to the Italian Referendum. Evidence of this can be seen in recent moves for Italian government bonds.

Italian flag
Source: Bloomberg

While financial markets are still metabolising Trump’s surprise win, investors appear to have already turned their attention to the next key event of this unpredictable 2016 — the Italian Constitutional Referendum.

There has been a wave of government bond selling worldwide, driven by expectations that Trump’s policies will stoke inflation and lead to interest rate increases. However, the impact on Italian government bonds is being amplified, a sign of the growing fear in the markets ahead of the referendum.

What will change after the US election?

Trump’s victory may well have strengthened the hand of populists in Europe and, in particular, in Italy. The referendum debate is already taking on more and more of the nuances and logic of the various political parties, and moving away from the main objectives of the reforms.

There are many who believe that a ‘No’ victory could lead to a government crisis for Prime Minister Matteo Renzi and an early general election, although this event appears quite unlikely given the lack of an electoral law. In such a scenario, a caretaker government seems likely.

Meanwhile, opinion polls continue to be mixed. The results often vary depending on the institution and the methodology of the poll. Uncertainty and skepticism are running high, especially as the pollsters got it wrong in the US elections just as they did for the Brexit vote in the UK and the 2015 elections in the same country.

Renzi versus Juncker

The referendum is also taking place against a backdrop of a continual clash between Renzi and European Commission President Jean Claude Juncker over the strictness of applying EU rules. The Italian prime minister has proposed a budget for 2017 that would not cut the country’s deficit by as much as EU rules require, but the pair have also clashed over a package for Turkey to stem migrant flows and over a deal with Russia regarding a pipeline. Juncker has accused Renzi of demonising the Commission in Italy.

The EU seems to be ignoring the strategic role that Rome plays in the EU and the potential negative impact on the country’s stability if the ‘No’ campaign wins. We believe that any favourable opening in Brussels before the referendum can be considered a victory for the government, and would help the ‘Yes’ campaign make up ground.

Italian government bonds

Fears over the referendum result are showing themselves in the government bond markets, where the sell-off that’s impacting the global market has been amplified in Italian government bonds, known as BTPs. The yield on the ten-year BTP rose to its highest since summer 2015, surpassing the 2% threshold. The spread to the German Bund on the same maturity has widened to over 170 basis points, the widest for 15 months.

Although spreads between Bunds and government bonds of the EU periphery have widened across the board, Italy has widened a little more. For example, the spread between the Bund and the Spanish ten-year rose to 52 basis points, a level not seen since the beginning of 2012. Up until June the yield between Rome and Madrid was roughly identical.

With just three weeks until the referendum, the latest auction of 30 years BTPs resulted in waning demand despite the recent increase in government bond yields. That’s a clear sign of the concerns around the referendum.

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