Italy’s bond yields rise sharply as Draghi government on brink

By Samuel Indyk

LONDON (Reuters) – Italy’s borrowing costs rose sharply on Monday and the premium investors demand for holding Italian debt over safer German peers was at its widest in a month as Italian political turmoil rumbled on.

Prime Minister Mario Draghi attempted to resign from his post on Thursday after the 5-Star Movement, a coalition partner, failed to back him in a confidence vote. Draghi’s resignation was rejected by the Italian president.

A source in the prime minister’s office said Draghi would not bow to any “ultimatums” from other parties and is determined to resign from his post.

Italy’s 10-year bond yield rose 10 basis points (bps) to as high as 3.48% in early trade, pushing the closely watched spread over German Bund yields to its widest level in over a month at around 235 bps.

Two-year yields rose almost 4 bps to 1.36%.

Euro zone bond yields were broadly higher but it was the move in Italy that stood out. German 10-year bond yields rose 6 bps, off seven-week lows hit Friday.

Draghi is expected to address parliament on Wednesday.

“We expect volatility to remain high until then in response to various rumours concerning whether he will remain firm on his resignation or whether he is willing to remain in place,” UniCredit analysts said in a note.

“Any indication that could increase the likelihood of early elections will ultimately be negative for BTPs and drive the spread wider.”

ECB RATE HIKE

Political instability in Italy comes in a week when the European Central Bank (ECB) is expected to raise interest rates for the first time in 11 years and announce details of a new anti-fragmentation tool to contain stress in bond markets.

The ECB has already flagged a 25 bps rate hike this Thursday and money markets price in around a 35% chance of an outsized 50 bps move, down from around 40% on Friday, according to Refinitiv data.

Markets price in 160 bps of tightening by year-end, implying that a hike of at least 50 bps could come at one or more of the ECB’s next four meetings.

Given growing concern about the economic outlook, the window of opportunity for the ECB to hike rates could be soon closing, analysts said.

“The window is closing rapidly, and I think this is what we see in terms of market pricing,” said Tatjana Greil-Castro, co-head of public markets and portfolio manager at Muzinich & Co.

“We struggle to see what’s going to happen in September — so many things can happen from here to there right now.”

The euro zone is grappling with an energy shock that has raised recession risks.

(Reporting by Samuel Indyk; additional reporting by Dhara Ranasinghe; editing by Dhara Ranasinghe and Gareth Jones)