Earlier this week the Italian Prime Minister Giuseppe Conte resigned after an intense parliamentary debate, triggering a government crisis. After fourteen months, the coalition between Five-Star Movement (5SM) and Lega, often seen as the most nationalist and populist Italian government in decades, has collapsed.
Italian bonds rallied after the news of Conte's resignation on the back of expectations of yet another iteration of the ECB's QE program in September. This resulted in the lowest interest rate levels since 2016 in Italy, with the spread in yield between Italy and Germany tightening by around 10 basis points.
Italian President Mattarella will now investigate the willingness of the different parties to form an alternative and stable majority. When a lack of ownership is observed, snap elections are unavoidable and could be called in the coming days.
According to opinion polls, Salvini's Lega would stand a good chance of winning if elections are held, given the increase in popularity that the party has experienced since the last voting. Lega's stance towards the EU, the fiscal pledges announced in the past, and the fact that other parties on the extreme-right side of the political spectrum would join the future governmental coalition makes the scenario of near-term snap elections the biggest risky outcome.
To avoid this scenario, 5SM has started talks with the Democratic Party (DP) to form an alternative government. While DP and 5SM have shown discrepancies in the past, the increased probability of such a coalition reflects that all cards are on the table.
A second scenario opens the door to a more market-friendly coalition, which might improve sentiment on the Italian bond market. However, with the current government crisis, budget proposals and subsequent negotiations with the European Commission will most likely be postponed. This might jeopardize the access of Italy to financial markets, which is essential to meet its financing needs until the end of the year. Besides, delaying budget negotiations until 2020 will not solve the fundamental issues that affect Italy.
We remain very cautious on the current situation, as all options are still possible. Market volatility in risky assets has been dampened by the ECB, as investors are expecting the announcement of expansionary measures in the coming September meeting. Sentiment on the Italian bond market could turn at any moment, depending on any updates from parliament. Even the return of a technocratic government has to be taken into account as a possibility, with independent experts ruling the country until the next elections. We see the probability of a positive outcome, a grand coalition or caretaker government, about equal to the probability of a negative outcome, namely snap elections or a reconciliation of the current 5SM-Lega coalition. With these equal probabilities, uncertainty and thus volatility will dominate the Italian bond market in the coming period.