(Bloomberg Opinion) -- While U.S. markets were closed on Monday for Memorial Day, in Europe, the establishment and investors displayed an unusual divergence of views. Elements of the establishment welcomed the decision by President Sergio Mattarella of Italy to appoint a technocratic prime minister. At the same time, markets sold off across the board, driven by the perception the move could increase the probability of significant turmoil not just in Italian markets but also elsewhere in Europe.
The latest twists and turns in Italian politics began May 27, when Mattarella rejected a proposal from the coalition of the Five Star Movement and League to appoint a finance minister, Paolo Savona, who the president considered too much of a euroskeptic and too opposed to Germany. In protest, the two parties ended their efforts to form a government and suggested Mattarella could be impeached.
Although he had several options, including calling immediate elections, the president chose the technocratic solution of naming Carlo Cottarelli as prime minister. The appointment of the highly respected former senior International Monetary Fund official who had also been in charge of the government's spending review was welcomed as a stabilizing move by many segments of the Italian establishment. The markets, however, sold off in earnest.
The 2 percent drop in stocks was accompanied by a notable increase in default risk perceptions as measured by the differential between Italian and German government bonds. Ten-year spreads widened to more than 230 basis points, a level not seen for a while. This was accompanied by a pronounced move at the shorter end of the yield curve, highlighting investor nervousness. Risk spreads on Greece, Portugal and Spain also widened, highlighting that market anxiety extends beyond Italy.
The tenure of Italy's new technocratic government is likely to prove short, and might not even last until the end of the year, as Cottarelli suggested in his initial public remarks. The new leaders could find it difficult to command sufficient support in parliament, and could soon be faced with a confidence vote that they could lose. The elections that would follow would likely be even more polarizing, sharpening the focus on Italy's membership of the euro zone.
For investors, that outlook involves more than just greater uncertainty. It evokes events that many had hoped had been relegated to the history books: the risk of redenomination of Italian securities should Italy end up leaving the euro zone. That, in turn, could entail the possible (though not probable at this stage) loss of backing by the European Central Bank's robust and volatility-repressing balance sheet.
That is why the widening in risk spreads in Italian bonds on Monday was a reflection of two different moves in markets: higher yields on Italian bonds and lower yields on German Bunds, which are widely and correctly regarded as the safe asset in a range of turmoil scenarios for the euro zone.
For now, the markets' assessment of the probability of these risks, while higher than a week ago, remains relatively low in absolute terms. That may not remain the case unless the new government is able to quickly develop and credibly signal broad-based support. Otherwise, Italy will likely face a series of credit-rating downgrades that would intensify pressures on financial assets, make it harder for the country's companies to secure funding and become a significant headwind to economic growth.
By rejecting the euroskeptic finance minister, Mattarelli hoped to secure a period of relative stability. Instead, financial market anxiety has risen with the greater possibility that Europe could become the central issue of an election, a development many politicians had wished to avoid after the experience with the Brexit referendum.
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