(Bloomberg) -- Italian two-year bonds plunged the most since the euro came into existence on concern the nation could leave the common currency.
The move coarsed through global financial markets, with investors shunning the securities of Europe’s southern nations and fleeing to the safety of U.S. Treasuries and U.K. gilts. Europe’s benchmark stocks index, the Stoxx 600, fell into negative territory for the year. In Italy, President Sergio Mattarella has summoned premier-designate Carlo Cottarelli later in the day, with a swearing-in ceremony possible tomorrow.
Liquidity in euro area bond markets dried up as dealers refused to offer quotes for parts of the Spanish bond market and most of Italy, according to two London-based traders who asked not to be identified because they aren’t authorized to speak publicly. The premium to cover a default in Italy’s debt jumped to the highest in nearly five years.
“The Italian house is on fire, and it will spread if someone doesn’t pull out the fire extinguisher soon,” Swedbank AB strategists Par Magnusson and Filip Andersson wrote in a note to clients. “Italy may become severely injured, but the EMU may die.”
The yield on Italy’s two-year bonds was up 158 basis points to 2.50 percent as of 12:09 a.m. in London, having touched 2.83 percent, the highest level since 2012. The rate on 10-year notes rose as much as 76 basis points to 3.44 percent, the highest level in more than four years.
In Spain, where prime minister Mariano Rajoy is facing a no-confidence vote, benchmark yields rose as much as 22 basis points to 1.74 percent. U.S. 10-year yields fell as much as 13 basis points to 2.80 percent, the lowest level since April 12, while comparable yields on U.K. gilts tumbled 22 basis points to 1.10 percent.
“Markets are in a ‘sell first and ask questions later’ mode so you can’t really tie this to specifics as much as it is fear of a worst-case scenario,” said Richard Kelly, head of global strategy at Toronto-Dominion Bank in London. “There is no question the kind of moves here are reminiscent of the Euro area debt crisis.”
Italy’s political struggles worsened over the weekend after President Mattarella vetoed the populist Five Star Movement-League’s choice for finance minister, effectively ending their quest to form a government. Markets had already been troubled by the coalition’s spending plans -- which were set to cost as much as 100 billion ($115 billion) euros -- but now a clash over Europe seems an increasing possibility. On Friday, Moody’s placed Italy’s debt rating under review for a possible downgrade.
Europe’s Stoxx 600 index fell as much as 1.8 percent, with most major European benchmarks in red for 2018. Italy’s FTSE MIB dropped 2.9 percent, with the FTSE Italia All Share bank index down 5.2 precent.
“This is a brutal wake-up call for investors who had forgotten about political risks in Europe and especially in Italy,” said Andrea Tueni, head of sales trading at Saxo Banque France. “Now the risk is that the populist parties gain ground in the next Italian election, which would be really bad news for the euro zone. Clearly, investors are moving to the sidelines for now.”
Credit-default swaps insuring Italian debt jumped by 59 percent to 262 basis points, the highest level since October 2013, signaling a deterioration in perceptions of credit quality.
For Toronto-Dominion’s Kelly, the next question for Italian bond investors is with whom the League forms a coalition in the run-up to an election. A pact with old allies Forza Italia, led by former prime minister Silvio Berlusconi, could soothe markets, he said.
Mattarella has asked Carlo Cottarelli, a former International Monetary Fund official, to form an interim administration, which will require a confidence vote in parliament. However, most parties are ready to go for a repeat election, and recent opinion polls show a significant pick-up in support for the League.
“One has to be concerned about forced selling flow in reaction to the price action,” said Antoine Bouvet, a strategist at Mizuho International Plc. “It is in Five Star’s and the League’s interest to benefit fully from Mattarella’s opposition by keeping a united front so there should be limited solace to be found in the near term from news flow.”
A key test of investor support for Italian bonds will come from 6 billion euros of supply Wednesday, Bouvet said.
©2018 Bloomberg L.P.