How Italian Bonds Will Respond To Upcoming Political Developments: A Flow-Chart

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The political situation in Italy following an inconclusive electoral result remains very uncertain. In order for the (barely) leading PM candidate – Bersani – to obtain a majority in the Senate, he requires the support of Berlusconi’s bloc or Grillo’s, or both, since potential ally and incumbent PM Monti cannot contribute a sufficient number of senators to ensure a joint majority.

The problem is that Grillo’s grass-roots support is based on enmity for the traditional ruling parties and apparently their poll numbers have risen since the election, so the pressure to compromise is minimal from their standpoint. In turn, Bersani has so far dismissed the possibility of working with Berlusconi’s PdLLega backers to form a government. Nonetheless, the latter remains the single most likely outcome, presumably with a centrist or technocratic PM and a limited, budget + reforms mandate. 

However, we cannot rule out a return to voting that could produce another impasse. Even if a government is formed, it is far from obvious as to whether it would stick to the successful ‘Monti Agenda’ of fiscal rigour and economic reform. The situation is fraught.

The Italian economic background is also quite problematic, judging from releases at the beginning of March. February manufacturing PMI fell from an already low reading of 47.8 to 45.8 and the unemployment rate jumped from 11.2% to a new high of 11.7%.

Against the very opaque political backdrop and poor economic news, fiscal performance remains a positive for Italy, where the annual deficit shrank by EUR8.5bn from 2011 to 2012. The cash requirement, however, did rise (by EUR6.5bn) due largely to Italian payments into European rescue funds (ESM, etc). This is one example of the ‘Eurostat’ deficit (3.0% of GDP in 2012) differing substantially from the funding requirement (closer to 4.4% of GDP). Such a divergence is a common occurrence, given ‘off-Eurostat’ and one-off transactions, and the same happened in Spain where the deficit was 6.8% of GDP not counting bank bailouts and 10% by another.

The following is a stylized flow chart illustrates the different possible outcomes for Italy's political developments and their impact on the 10Y BTP spread.