LONDON: Even before the final outcome of France's presidential race, investors are shifting focus to potentially bigger risks emanating from the eurozone's third biggest economy, Italy.
Centrist Emmanuel Macron's first-round win on Sunday, which puts him on track to beat anti-euro Marine Le Pen in a May 7 run-off, has eased worries about eurozone break-up risks and sparked a sharp rally in French and Italian government bonds.
But in Italy, where anti-euro sentiment is strong and elections loom in early 2018 if not sooner, relief over the French vote has already faded: Italian bonds were among the worst performing on eurozone debt markets on Tuesday.
The gap between Italian 10-year bond yields and top-rated German equivalents stood at 188 basis points, up from seven-week lows hit on Monday at around 180 bps. The spread is often seen as a gauge of how investors view political risks in Italy and the single-currency bloc.
"An Italian election is potentially the most dangerous event in Europe at the moment because of the fragile and shifting political situation in Italy," said Lorenzo Codogno, a visiting professor at the London School of Economics and chief economist at LC Macro Advisors.
"What worries financial markets the most is an Italian exit from the monetary union and the risk of an anti-establishment movement coming to power," said Codogno, a former chief economist at the Italian finance ministry's treasury department.
Recent opinion polls give a clear and growing lead to the anti-establishment 5-Star Movement, which wants to hold a referendum on Italy's continued membership of the eurozone.
With other eurosceptic parties also doing well, analysts say political uncertainty in Italy, which is struggling with a weak economy, frail banking sector and high debt levels, is quickly replacing France as the big market risk ahead.
"The risk is important in Italy, maybe even more so than in France, because some polls indicate that Italian citizens are less in favour of the euro currency than in France," said Geoffroy Lenoir, head of euro sovereign rates at Aviva Investors in Paris. "If we had an election today, 5-Star could win."
Sunday's French vote may have restored market faith in opinion polls, which picked the two candidates who made it into the run-off, suggesting investors may become increasingly sensitive to Italian polls once an election date is set.
The ruling Democratic Party holds a leadership election this Sunday and if former prime minister Matteo Renzi wins, he may push for an early vote, analysts said.
"My reading of Italy's situation is that you got rid of Renzi, and it appears that it is not ready to make big reforms, and to be honest the easy option of leaving the euro is still on the table so I don't think populism is dead in Italy at all," said David Hussey, fund manager at Manulife in London.
WEAKEST LINK
Ratings agency Fitch downgraded Italy's sovereign debt to BBB from BBB+ on Friday. S&P Global, which rates Italy BBB- with a stable outlook, is due to review the country on May 5. A ratings downgrade can put further pressure on borrowing costs.
ABN AMRO senior fixed income strategist Kim Liu said Italian government bonds were "particularly vulnerable" to the country's political risks, economic weakness and high debts.
ABN expects the Italian/German yield gap to widen to 240 basis points by year end - some 50 basis points above current levels.
There are other signs of investor unease over holding Italian bonds.
The cost of insuring exposure to Italian government bonds, as measured by credit default swaps, is higher than for some big emerging market economies such as Russia and Indonesia.
David Vickers, a senior portfolio manager at Russell Investments, said Italian risks were one reason why the firm has reduced its exposure to Italian credit.
"The widening in corporate spreads (over government bonds) just isn't enough to compensate for the risks out there," he said. "And with tapering coming off, I struggle to see a name in Italian credit that steps up to the plate."
An improving eurozone economy and an ebbing of political risks has fuelled speculation about Eueopean Central Bank (ECB) tapering - a move that bond strategists say is likely to lead to sharp widening of bond spreads in peripheral Europe.
"In the absence of the ECB, Italian bonds look unloved," said Vickers. - Reuters
Win a prize this Mother's Day by subscribing to our annual plan now! T&C applies.
