It seems that the only thing that unites the parties in the Conte II government is that it wants to avoid at all costs that new elections are held, which could result in a majority for Matteo Salvini’s Lega party (the right-wing populist party initially was in a coalition with M5S in the Conte I government following the last elections of March 2018). Mr Salvini’s Lega is part of a right-wing coalition, which according to recent opinion polls would receive close to 50% of the votes. A regional election – on 26 January in Emilia Romogna – could put more pressure on the governing coalition, if Lega has a strong showing. Nevertheless, we think it is likely that the current government will stay in power given that political survival is a strong driver. Still, the political situation will remain unstable and we think there remains significant probability of early elections at a later stage.

Euro Rates: Snap elections could see spreads temporarily in the 200-250bp region – Italy’s government bonds have not seen a significant impact from the political instability over the last few days, underperforming German and peripheral counterparts very modestly. Under a scenario of snap elections, upside for the Italy-Germany 10y spread is significant. For instance, the collapse of the populist coalition in August of last year saw spreads soar to the 200-250bp range (compared to 160bp currently), though spreads collapsed as the Conte II government came into view.

The jump in spreads  following the formation of the populist Conte I coalition was even more extreme – in the 250 – 300bp region – and those ranges lasted for a good part of a year. Though we judge that there was a significant redenomination risk premium at the time, so spreads are unlikely to jump quite as far this time. In that sense, the August 2019 episode is probably a better indicator of where spreads could go if there were to be a snap election.

However, we think spreads would likely settle down after any snap election, even assuming a Salvini-led government would come into place. Although a Salvini government may push for further fiscal stimulus – likely in the form of tax cuts – it could also drop some of the expensive – more left-wing – measures of the current government.

Under our base case, where a snap election is avoided, we think there is room for Italian government bonds to perform versus their German counterparts. There is already a significant political risk premium embedded in current spreads. The chart above on sovereign ratings (average of S&P, Moody’s and Fitch) versus spreads for different countries is an illustration of this. Italian government debt looks to be priced at sub-investment grade levels on this metric, even though that is not currently the case (or likely to be soon). In addition, we think the ECB’s QE programme (which should eventually be stepped up) and the search for yield will be supportive elements. On the other hand, the risk of a government collapse will not fully dissipate, so volatility will likely remain high. Our 3-month forecast for the Italy-Germany spread – assuming no snap election – remains 130bp.