Pressure heaped on ECB as Italian bonds and stocks drop on Draghi resignation

Italian bonds and stocks dropped after Mario Draghi resigned as the country’s prime minister, setting the stage for snap elections and threatening to unleash a fresh phase of turmoil for the nation’s debt.

The latest political crisis doesn’t just create uncertainty for Italy. It also ups the pressure on the European Central Bank (ECB), which is just hours away from announcing a new bond-purchase programme intended to shield countries such as Italy from market speculation. It’s had to design such a tool as it prepares to increase interest rates for the first time in more than a decade.

Investor reaction to the news from Italy was clear, with the yield on the country’s 10-year note jumping as much as 21 basis points to 3.6 per cent, its highest since June. The spread over equivalent German bonds, a common gauge of risk, rose to 233 basis points. Citi sees the gap reaching 250 to 275 basis points in the event of an election.

There was also a sell-off in stocks, with the FTSE MIB falling 2.6 per cent.

This is “not a good day to be invested in Italy, said Sebastien Galy, senior macro strategist at Nordea Asset Management.

Political chaos in Italy could “soften the ECB’s hand when it comes to rate hikes, said Ipek Ozkardeskaya, senior analyst at Swissquote Bank. Traders stared paring rate bets ahead of the decision, with the odds of a 50-basis-point increase falling to less than 50 per cent. Speculation had been building over the past few days that the ECB could deliver a half-point hike, double what policy makers had previously indicated.

The euro gave up an early gain against the dollar to trade little changed at $1.0184 as of mid-morning.

The news also adds to the litany of troubles for the European Union, which is already grappling with the fallout from Russia’s invasion of Ukraine, an energy crisis that’s sent inflation across the region soaring and the threat of a recession. For Italy, it casts doubt over the budget and progress on reforms needed to unlock €200 billion in aid from the EU.

Three of Mr Draghi’s coalition partners withdrew their support Wednesday night after he forced a confidence vote by threatening to quit. Mr Draghi announced his resignation to president Sergio Mattarella in a meeting on Thursday morning The government will continue as a caretaker to handle ongoing business.

Goldman Sachs Group economists said the developments are “adding policy uncertainty to the economic risk posed by the energy crisis.

Attention now turns to the ECB, set to make a hugely anticipated policy announcement at 1.15pm. In addition to a rate hike, the focus will be on its plan to contain the fallout from higher rates on weaker economies in the region. The Italy upheaval complicates the ECB’s task because the instrument is intended to curb unwarranted spikes in sovereign yields as monetary policy shifts, rather than soften the market impact of domestic events.

“This creates a tremendous communications challenge for the ECB, said Peter Chatwell, head of global macro strategies trading at Mizuho International. “The anti-fragmentation tool arguably has no place to intervene in the market’s valuation of sovereign risk during a political crisis, as the political crisis could turn out to change the credit quality of the sovereign. — Bloomberg