Italian Bonds Underperform as 5 Star Split Weakens Draghi's Govt

© Reuters.

By Geoffrey Smith

Investing.com -- The risk premium on Italy's bonds increased on Wednesday after one of the parties that Prime Minister Mario Draghi depends on for his parliamentary majority split over its policy toward Ukraine.

Foreign Minister Luigi di Maio confirmed on Tuesday that he will leave the 5 Star Movement, the biggest party in Draghi's de facto coalition, over the refusal of its leader Giuseppe Conte to support the shipment of arms to Ukraine to defend itself against the invading Russian forces.

The split raises the likelihood that 5 Star, under Conte, will leave Draghi's government, narrowing the political base for a government that has no direct democratic mandate.

By 05:45 a.m. ET (0945 GMT), the Spread between Italian and German 10-year bond yields, a traditional barometer of Eurozone breakup risk, had widened to 206 basis points, from 199 at Tuesday's close. Italy's benchmark stock index, the FTSE MIB, was also the worst performer among the main European indices, with a drop of 2.5%. 

Draghi was called upon to take over as Prime Minister in 2021 after the previous coalition collapsed under the strain of managing Italy's response to the pandemic. While the pandemic emergency initially guaranteed Draghi a huge majority in parliament which was unusual for Italy, support for it has frayed in recent months, as Draghi's outspoken support for Ukraine has gone against the traditional sympathy for Russia found on both the left and right-wing fringes of Italian politics. Elections aren't due until 2023.

The Italian economy - which is almost completely dependent on imported fossil fuels - has come under intense pressure from the surge in oil and gas prices this year. Despite that, Draghi has supported all of the western initiatives to sanction and isolate Russia. Italy's Senate approved a bill shipping more weapons to Ukraine earlier this week.

Financial markets have seen the presence of the former European Central Bank President as an essential condition for preventing renewed stress between Italy and the rest of the Eurozone at a time when government budget deficits have widened sharply, exposing the chronic weakness of Italy's sovereign balance sheet. The BTP-Bund spread has soared in recent weeks as the ECB ended a bond-buying policy that allowed it to give more support to the Eurozone's weaker members. Tighter monetary policy in the U.S. has also had the effect of dragging Eurozone yields higher in that time.

The benchmark 10-year yield had hit a nine-year high of 4.28% last week, approaching a level that analysts say will be difficult to sustain in the long term given Italy's low growth over the last two decades. It has since eased to 3.73%, as fears of a recession have triggered inflows to bonds, which are still regarded as lower-risk than equities.