The calm of the bond market in the face of a possible government reshuffle in Italy and the French elections in April offers proof, if it were needed, that Europe’s show of solidarity during the pandemic has all but wiped out the risks of breakup of the euro.
The build-up to these events is very different from 2017 and 2018, when the prospect of a far-right, eurosceptic French presidency and Italian politicians’ clashes with Brussels respectively set the eurozone’s breakout gauges on fire.
Fears of ‘Frexit’ and ‘Quitaly’ – the risk of these countries abandoning the single currency, causing the bloc to break up – were also high following Britain’s shock Brexit referendum in 2016.
But France’s April presidential election isn’t much on the radar, despite the possibility of a far-right candidate making it to the second round.
Markets are also mostly unfazed by the kickoff of Italy’s presidential election on Jan. 24, which could see Prime Minister Mario Draghi become president and possibly trigger a snap election that could result in a potentially choppy coalition.
Diminishing fears of a breakup of the eurozone this time around reflects a change in rhetoric after the pandemic highlighted the benefits of joining the bloc for the most indebted states.
“Anti-euro rhetoric is not so fashionable anymore after the pandemic and the NGEU,” said Mauro Valle, portfolio manager at Generali Investments Partners, referring to the European Union Recovery Fund created in 2020 to shell out up to 800 billion euros ($917.44). billion) to Member States.
As the presidential vote approaches in Italy, Italian yield spreads above the regional benchmark Germany – premium investor demand for exposure to Italy, the second most indebted economy in the euro zone – widened by around 140 basis points, up 10 basis points since the end of November.
But that’s less than half of what it was in October 2018 DE10IT10=RR.
Similarly, French spreads, which exceeded 80 bps at the start of 2017, are now around 30 bps DE10FR10=RR.
“On a scale of 1 to 10 where 10 is maximum panic, I think we can still be around 1 or 2,” said UBS strategist Rohan Khanna.
“As far as Italy is concerned… the questions on how to hedge this (political) risk have just started,” Khanna said.
Khanna said he fielded questions from clients last year about French risks, but those have since diminished, perhaps as far-right campaigns waned.
While Italian and French yields have risen since early December and Italian spreads over Germany have widened, this is part of a broad-based rise driven by higher borrowing costs around the world and the slowdown impending bond purchases by the European Central Bank.
So, while in 2017 and 2018, the Franco-German and Italian-German spreads jumped by around 50 bps and 180 bps respectively, most investors approached by Reuters do not expect more than 20-25 bps widening of Italian spreads during the vote on a new president and his sequel.
French spreads are also expected to move slightly and a Deutsche Bank survey in December found that only 1% of respondents expect the election to be a major event for financial markets.
And there’s no sign of a safety bid causing momentum for German bonds, where yields have risen as elsewhere.
Any election comes with risk, and for Allianz Global Investors’ Mike Riddell, that’s a reason to short Italian and French bonds “not because we think there’s going to be a massive upheaval, it’s just that there is so little risk that it will be taken into account”.
The polls themselves could bring some relief to investors, with the latest in France showing that either of the two far-right candidates may not make it to the second round, meaning conservative Valérie Pécresse could face incumbent Emmanuel Macron instead.
But the biggest change this time around is that far-right politicians have generally dampened euroscepticism, notes Valle of Generali Investments Partners, which is overweight Italian bonds and sees any selling as a chance to increase allocations.
The creation of the European Union Recovery Fund, in particular, is seen as a turning point for the EU, allowing joint borrowing on a scale unthinkable in previous crises.
The pandemic has also helped Germany come to terms with the need for higher spending and joint borrowing; a new Social Democrat-led government has signaled its openness to reforming eurozone spending rules, which are currently on hold.
Italy, where far-right leader Matteo Salvini has called bond investors “lords of the spread”, is the main beneficiary of the fund and the EU’s decision to suspend debt rules.
He will receive up to 205 billion euros from the fund in the form of loans and grants, which UBS’s Khanna described as a “welcome gift” to any new Italian leader and a powerful incentive to stay on good terms with the block.
“They can’t live without it,” he added.
Source: Reuters (Reporting by Stefano Rebaudo and Yoruk Bahceli, additional reporting by Dhara Ranasinghe; editing by Sujata Rao and Susan Fenton)