Italian bonds suffer worst day in over 25 years

A deepening political crisis in Italy, the euro zone's third biggest economy, fuelled a selloff in Italian assets and the euro on Tuesday that was reminiscent of the euro zone debt crisis of 2010-2012. Short-term Italian bond yields suffered the biggest one-day jump since 1992, while Italian and wider euro zone banking stocks saw their worst day since August 2016.
At an auction of six-month debt, the government had to pay investors the highest yield in more than five years. The moves come after Italy's president appointed a former International Monetary Fund official as interim prime minister, with the task of planning for snap polls and passing a budget.
Investors believe the election - which sources said could be as early as July 29 - will deliver an even stronger mandate for anti-establishment, eurosceptic politicians, casting doubt on the Italy's future in the euro zone. "We are pricing in a total lack of confidence in the outlook for Italian public finances," said Giuseppe Sersale, fund manager at Anthilia Capital Partners in Milan.
The Italian-German 10-year bond yield spread, seen by many investors as an indicator of sentiment towards the euro zone, hit its widest since June 2013.
The spread rose above 300 basis points, having almost tripled from end-April levels around 115 bps, though it closed below the 300 bps mark. In 2011, at the height of the euro debt crisis, that gap was at 560 bps.
Italy's 2-year yield spiked more than 150 bps at one point to 2.73 percent, while 10-year bond yields jumped 50 bps to their highest level in over four years at 3.38 percent before easing slightly from session highs.
Italian bond yields traded above US Treasury yields for the first time in almost a year. The Italian 2-10 year bond yield spread narrowed to 44 bps - its tightest since 2011 - having been at 220 bps a week ago. Spain's 10-year bond yields rose to seven-month highs above 1.66 percent and its spread with Germany rose to its widest in over a year.
Italy's central bank chief warned the state was only "a few short steps" from losing investors' trust. Ratings agency Moody's said Italy was likely to face a downgrade if a new government pursued fiscal policies that do not put debt levels on a sustainable downward path.
While the 5-Star Movement and far-right League have dropped plans to take power, they have switched to campaign mode. 5-Star has called for protests against President Sergio Mattarella's rejection of the parties' nominee for economy minister, who has argued for Italy to quit the euro. So far, the European Central Bank's bond buying programme has provided a backstop for euro zone government debt, but latest market moves suggest this buffer may have lost its punch.
"With such an unclear Italian political situation, investors will continue to demand a significant uncertainty premium," said Isabelle Vic-Philippe, head of euro government bonds at Amundi, one of Europe's largest investors.
The cost of insuring exposure to Italian risk in the five-year credit default swaps market touched a 4-1/2 year high of 225 basis points, a jump of 49 basis points on the day, data from IHS Markit showed.