(Bloomberg) -- All of a sudden politics matters to Italian bonds. Disruption around an election process that was never smooth to begin with drove 10-year yields up 10 basis points on Tuesday to 1.85 percent, the highest level for six weeks.
In the process most of the spread tightening to German bunds since the March 4 election went away.
All attempts to cobble together some form of coalition since the inconclusive vote have failed. And now the president's latest proposals for a neutral prime minister have been rejected by both the populist Five Star movement and the League.
Five Star is agitating for fresh elections as soon as July. The League has also backed a return to the polls if the parties can't reach a last-ditch compromise.
While it would be unprecedented for a second election to occur so soon, it may become impossible for President Sergio Mattarella to resist if all the other constitutional options fall away.
The president's main concern has been the safe passage through parliament of the 2019 budget – without this, funding won’t get approved and Europe’s most indebted nation could face a shutdown that would make the American government debt crisis look like a walk in the park. A summer election would derail the autumn legislative timetable and threaten the government's ability to function.
Investors have been fairly relaxed about Italy, expecting the current technocratic government to continue until new elections, which they'd expected to come around spring of next year. But it is a bigger concern that the state could potentially grind to a halt while the budget hangs in limbo, especially as there is not much hope for a conclusive result from any future election. Were the president to determine that elections must wait until the budget is passed, that could be taken as such an anti-democratic move that it would create even more political disruption than we’re seeing now.
Something normally turns up in Italian politics, which gives serious meaning to the art of the compromise. Until then, Italian yields could well back up to the two percent level seen earlier this year. But on any sign of a deal they will snap right back -- that extra yield over Germany is just too tempting in a ultra-low yield environment.
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