What Referendum Thoughts of a Draghi Put Restore Calm

(Bloomberg Gadfly) -- The initial market reaction to the Italian referendum is too good to be true. Say hello to the Draghi put.

The "no" vote on constitutional reform on Sunday at first pushed the euro down to almost the lowest since March 2015, but it's starting to recover. The selloff in the 10-year Italian government bond never made it as far as lows seen last week, and it's also on the way up.

What Referendum Thoughts of a Draghi Put Restore Calm

This was a big loss for Prime Minister Matteo Renzi, who has resigned, but investors seem to be saying: "Nothing to see here, please move along." It looks a lot like the European Central Bank's been at work already, and there's a larger expectation that President Mario Draghi will, if needed, spring into action at Thursday's policy meeting. There's also the prospect of a positive message of support from European finance ministers meeting this morning in Brussels to discuss the ongoing Greek bailout. 

It would be quite easy for the ECB to marshal its defenses on supporting the Italian government bond market. For instance, it can bring forward bond purchases that it's already planned, or tweak the capital key -- a rule that the allocation of purchases should be roughly proportional to the size of each economy --  to focus more buying toward Italy. These would be temporary fixes.

What Referendum Thoughts of a Draghi Put Restore Calm

In the long term, there are deeper worries in store. Ultimately the real test for Italy's ability to ride this political setback will be how the credit markets react.

A key test is whether the equity capital raising currently underway by Banca Monte dei Paschi di Siena SpA goes ahead as planned, and whether a cornerstone investor can be found to reduce the amount investment banks and the wider market have to underwrite. Given the circumstances, you'd expect the deal to be canceled. But the surprising market stability leaves room for it to have a short delay, or even just to go ahead as planned.

But if it falls apart, then a bail-in of junior bondholders and potentially a much larger overall Italian bank bailout program with state aid looms. A minor delay or rejigging of terms can be handled, but recapitalization of Monte Paschi and the Italian banking system cannot be put off for long. The Italian drama we were expecting may be only delayed.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story: Marcus Ashworth in London at mashworth4@bloomberg.net.