Markets Unfazed by Rising Risk of Populism in Italy…for Now

While Italy’s bond yields have risen, investors have so far reacted relatively calmly to the rising probability of a populist Italian government. Based on the fundamentals, the potential downside scenario looms larger than markets seem willing to consider.

After weeks of feverish negotiations (and with a last-minute request for more time), the anti-establishment Five Star Movement (M5S) and right-wing League (formerly the separatist Northern League) are working to reach an agreement to form Italy’s next government. It’s uncertain how long such a government would last, but populist leadership could have big implications for Europe’s markets.

The arrival of a populist government in Italy should come as no real surprise—not even to Europe’s political establishment. As we’ve highlighted in the past, Italy’s recent economic performance has been truly abysmal. And, coincidence or not, its relative position has deteriorated markedly since it joined the euro (Display).

Capital Markets Shrug Their Shoulders

So far, financial markets have reacted relatively calmly to these developments, with the yield spread between the 10-year Italian bond and German Bunds rising from a low of 113 basis points in late April to 156 basis points as of May 17. However, this only takes the spread back to where it was at the beginning of January.

The most obvious reason for the modest reaction is that European Central Bank (ECB) bond purchases continue to provide a backstop for the market. And Italy’s yield spread versus Spain suggests that a political risk premium is already attached to Italian bonds (Display).

There are other plausible explanations. Investors may think that the government won’t last long—or that it will act very differently once it gets to sit at the high table (think Greece’s Syriza). The market probably also draws some comfort from the recently toned-down anti-euro rhetoric of both M5S and the League.