Italy's borrowing costs rose on Monday after Prime Minister Matteo Renzi said he would resign following a crushing referendum defeat, although expectations that a snap election would be averted helped contain the sell-off. Investors had been positioned for a 'No' vote in Sunday's referendum, but signs that investors were closing short positions across Italian assets and the euro, which bounced back from 21-month lows, lent bond markets some support.
Allianz Global Investors said it had reduced its short position on Italian government bonds on expectations an interim government would fill the void set to be left by Renzi. A recent rise in outstanding contracts in Italian government bond futures, a tell-tale sign of shorting when coupled with price falls, kicked into reverse last week in a sign that others were scaling back bets against Italian debt.
David Zahn, the head of European fixed income at Franklin Templeton, said that at current yields - around 2 percent on 10-year paper - Italian bonds looked attractive and he would consider reducing an underweight position. "The referendum does bring some clarity and we don't have that hanging over us any more. Now it depends on what the government decides to do," Zahn said. "I don't envision we will have early elections in Italy."
Renzi's constitutional reform was rejected by 59.1 percent of voters, a wider margin than had been expected. The resounding 'No' vote follows Britain's decision to quit the European Union in June and the unexpected election of Donald Trump as the next US president last month. Italy is teetering on the brink of a rating downgrade that could raise costs in its beleagured banking sector. Ratings firm DBRS said Renzi's exit was "negative" for Italy's A(low) rank, which allows banks to receive favourable funding rates from the European Central Bank.
Italian shares were volatile, dipping in and out of the red. Shares in the country's third largest lender Monte dei Paschi - currently trying to persuade investors to back an emergency recapitalisation - fell 6 percent, while an index of Italian bank shares fell 2.5 percent. The link between Italy's banks and bond market is a major concern for investors. Banks, which hold large amounts of government debt, have been hit by worries over their exposure to bad loans built up during years of economic downturn.
Italy's 10-year government bond yield shot up as much as 14 basis points (bps) to 2.07 percent, but closed at 1.98 percent and held below a 14-month high of 2.17 percent touched in late November. German 10-year yields - the euro zone benchmark - initially fell as the referendum results boosted demand for safe-haven bonds, but soon reversed track to close up 5 bps at 0.33 percent .
The market impact was limited as focus turned to Thursday's meeting of the European Central Bank and expectations that it would provide supportive rhetoric. Sources told Reuters last week the ECB was ready to buy more Italian bonds if the referendum results unsettled markets. However, there were no signs of unusual ECB buying on Monday, traders said. The gap between Italian and German yields widened to around 170 bps from around 163 bps on Friday. But the spread held below recent 2 1/2-year peaks over 190 bps, a sign that the selling in Italian bonds was contained.