At some point, the gorgeous, three-decade-long bond rally had to come to a close, since all good things must end. But who would have thought Italy would join Donald Trump as the agent of its destruction.
On the day after the Nov. 8 election, U.S Treasury bonds took their biggest plunge in five years. Until then, bonds had gained 3.8 per cent in the year. In the summer, the yield on benchmark 10-year Treasuries was 1.3 per cent. By Friday, their yield had climbed to 2.38 per cent as investors hammered the sell button. Their fear is that Mr. Trump's pledge to stimulate the economy with thumping great tax cuts and $1-trillion (U.S.) in infrastructure spending will trigger higher deficits and stoke inflation, and they're probably right.
Not to be outdone, the Italians decided to create a little political mess of their own that is rattling the bond markets. Italian bonds matter. Italy, which is sagging under €2.2-trillion ($3.15-trillion Canadian) in debt, runs the world's third largest bond market, after the United States and Japan.
The mess in question is the Dec. 4 referendum on constitutional reform, which Prime Minister Matteo Renzi, the reforms' main cheerleader, seems set to lose. Bond investors are freaked out by the potential political chaos that a No vote would unleash, since Mr. Renzi has said he would hit the road if the vote goes against him, leaving a power vacuum that could be filled by the populist, anti-establishment Five Star Movement (M5S), the main opposition party.
Investors may have overreacted. The referendum itself is not the big risk. Instead, it's the election that will happen after it. But that election may not get called until mid-2018. More than a few economists and market strategists agree that the risk of the referendum itself is overstated. Italy's Mediobanca Securities suggests investors "buy into the dip."
The dip is under way. In the past month, the yield on Italian 10-year bonds has climbed 71 basis points, to 2.1 per cent, as prices fell (100 basis points equals 1 percentage point). The increase vastly outpaces the rises of other European Union bonds, even those of Brexit-bound Britain and France, which could elect Marine Le Pen, an EU-hating, protectionist xenophobe, in next spring's presidential elections.
Four or five years ago, at the height of the European debt crisis, the yield on Italian 10-year debt went as high as 7.8 per cent and there was grim talk of a bailout, except that no one could figure out how to save a Group of Seven country with a crushing debt-to-gross domestic product ratio of 128 per cent (now 133 per cent), Europe's second highest, after Greece. The shambolic Italian banking system, laden with €360-billion in impaired loans, only heightened concerns the country was on a suicide run.
Some deft fire fighting by the European Central Bank, including a bond-buying program, a flood of cheap loans for banks and, lately, an enormous quantitative-easing program, took Italian bonds out of the emergency ward. A year ago, their yield had fallen to about 1.4 per cent – money for nothing, really.
The new fear is a No vote in next weekend's referendum. Investors seem to think that rejection of the constitutional reforms – essentially the downgrading of the upper house, the Senate, into a largely powerless blather council – would plunge Italy into chaos. It would not. Instead, the status quo would persist and life would go on.
Of course, it's not that simple, because of Mr. Renzi's vow to resign if he loses the referendum. To be sure, he will tender his resignation, but Italy's stability-minded president, Sergio Mattarella, may not let him go before the regular parliament ends in mid-2018. Or he may ask another centre-left politician or a technocrat to lead a government until then. The prospect of a snap election right after the referendum is exceedingly low.
The wrinkle in the scenario has little to do with the referendum and a lot to do with Italy's new electoral law, called the Italicum, which would guarantee a solid majority to the leading party through the awarding of bonus seats. A couple of years ago, when Mr. Renzi's Democratic Party was way ahead in the polls, the Italicum was a dream come true for the centre left. Now it's a nightmare, because M5S has come on strong and is now roughly equal to the Democrats in the polls, at 30 per cent.
In other words, a "drain the swamp" protest party, led by a loudmouth former-comedian named Beppe Grillo, could get a super majority if an election were held today. He wants a referendum on the euro and resuscitation of the old lira, a currency that suffered from endless devaluations.
If Italy, the third-largest economy in the euro zone, were to leave the euro, the euro zone would die, perhaps the wider EU, too.
Surprise – Mr. Renzi, who is not keen to end his political career at age 41, now wants to change the electoral law, presumably ending the winner-take-all premium for the top party. To do otherwise would stack the cards in M5S's favour in the next election.
The game now is reforming the electoral law to prevent M5S from gaining more support and winning an election. The party's victory may never happen, or if it does, it could be a long way off. Bond investors should hold the panic. In Italy, it's simply chaos as usual.