Italy: This is the end?

It was never going to be one of the Eurozone minnows that could sink the euro. The danger of that was always lurking from one of the bond market behemoths – Italy or Spain. In the last few years, Greece, Ireland, and Portugal have rocked the Eurozone boat to its very core. But this time it could be Italy that takes the euro down with all hands. Italian politics have always been a nightmare and it is no exaggeration to say that this could mark the beginning of the end for the single currency. We could have entered the worst case scenario of ungovernable Italy. With Italy now facing a political deadlock after the election shock, hopes for stable government, committed to on-going fiscal austerity and structural reforms, have been swept aside. Clearly, the major winner is uncertainty with market perceptions left in disarray again.

You have to pity the nation. Clearly voters have had enough of force-fed austerity and rising double-digit unemployment. With the economy already under water for 5 successive quarters of recession and no signs of coming up for air soon, it was no surprise voters would look for an alternative to the mainstream parties. The election turned into a massive protest vote with the anti-establishment 5-Star Movement, clearly the biggest winner, gaining more votes than any other single party. Italy is now in political gridlock. While the pro-reform centre-left looks set to take control in the lower house, there is no clear winner in the upper house. Unless the opposing mainstream parties of the centre left and right are able to bury the hatchet and formulate some sort of governing grand coalition, Italy looks set for a period of political instability and new elections ahead.

During past political crises, when Italy had its own currency the contagion effect abroad could be reasonably well quarantined. But now with Italy forming a key part of the euro, there is major contagion risk ahead for global markets. Whether or not we are facing an Armageddon scenario will be down to Italian parties settling differences and getting the country back on budget track again. But if this is a start of a new order and distressed Eurozone voters saying no to tough times, there will be trouble ahead.

De-convergence trades are the order of the day again. Euro sentiment has been holed below the water-line and Italian bond spreads have gapped up again. This is no storm in a tea-cup but the mark of a deeper sea-change for a while. Over the last 7 months as the ECB has thrown its weight behind Eurozone survival, the Draghi ‘put’ has had a lot of success in settling market nerves. But that process pre-supposed that collectively everyone and everything would fall into line and do their bit. Continuing fiscal austerity, on-going structural reforms and voter acceptance, were all supposed to be part of that process. Those assumptions now appear to be foundering on the rocks of the Italian election. There was always a sense of deck chairs being re-arranged on the Titanic. If the euro is going down, the suction effect on global markets will be fierce.

If this is the start of the slide back down the slippery slope into Eurozone contagion, then the brave new world of the euro is over. The markets can only wonder if time will finally be called by disaffected Eurozone voters. Or whether Germany pips them at the post and decides it has had enough and throws in the towel. Despite the big easy in global monetary reflation, it may be time to go long of tin-hat futures again.