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June 6, 2018, 2:25 a.m. EDT

Here’s why Italy and financial markets are still headed for a showdown

Analysis: Italy’s fiscal plans set stage for more potential turmoil

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By William Watts, MarketWatch

AFP/Getty Images
Italy Prime Minister Giuseppe Conte.

Will investors really forget about Italy so soon after last week’s turmoil?

Telling parliament that a “new wind” was blowing in Italy, newly installed Prime Minister Giuseppe Conte on Tuesday served up a reminder that the coalition government he heads remains on a collision course with its eurozone partners and financial markets as they attempt to shake off years of austerity.

In his maiden speech, Conte, the little-known academic tapped to lead the government formed by the antiestablishment 5 Star Movement and the hard-right League, promised to implement the pair’s main fiscal policy priorities. These include cutting corporate and individual taxes to as low as 15% and expanding welfare benefits to the country’s poor and unemployed.

Those measures are estimated to add around 70 billion euros ($82.1 billion), equal to around 4% of gross domestic product, said Nick Kounis and Aline Schuilling, economists at ABN Amro, in a note. They would also push the government debt-to-gross domestic product ratio to 180% in 2030, up from around 132% in 2017.

In addition to violating the EU’s budget rules, that’s unsurprisingly unwelcome news for Italian government bonds, where yields jumped on Tuesday.

“If these fiscal risks were to materialize, Italian assets would see significant more downside. In a sign that Prime Minister Conte would not easily yield to pressure from Europe to stick to the fiscal rules, he talked up Italy’s ‘negotiating power,” the economists wrote. “Indeed, the Italian government would not lay down as easily as the government of Greece has over the years, when faced with a confrontation with Brussels and Berlin.”

The yield on the two-year Italian note /zigman2/quotes/211347219/realtime BX:TMBMKIT-02Y -2.27%  jumped 20 basis points to 0.973%, while the 10-year Italian yield /zigman2/quotes/211347230/realtime BX:TMBMKIT-10Y -2.74% rose a similar amount to 2.751%. More crucially, the premium demanded by investors to hold Italy’s 10-year paper over /zigman2/quotes/211347112/realtime BX:TMBMKDE-10Y -3.39% German bunds, perceived as safer, widened by around 26 basis points to around 2.4 percentage points.

Meanwhile, the euro /zigman2/quotes/210561242/realtime/sampled EURUSD -0.5686% also came under pressure, but turned higher after a news report said European Central Bank officials would use next week’s meeting to discuss the timing of the unwind of its bond-buying program. Italy’s FTSE MIB /zigman2/quotes/210598024/delayed IT:I945 +0.34%  stock index fell 1.2%, while the U.S.-listed iShares MSCI Italy ETF /zigman2/quotes/207981587/composite EWI +0.03%  fell 1%.

Check out: Think the Italy panic was bad? Just wait until central banks turn off the spigot

Yields, which fall as debt prices rise, remain well off the peak seen last week when the 10-year Italian yield spiked above 2.90% on fears a political impasse, which was subsequently overcome, would result in fresh elections that could turn into a de facto referendum on Italy’s membership in the European Union. That turmoil rippled through global financial markets, sparking a short-lived global equity selloff that also dragged down U.S. stocks, as gauged by the S&P 500 index /zigman2/quotes/210599714/realtime SPX +1.44% .

Read: Here’s how Italy revived euro crisis fears and sparked a global stock market selloff

While the reaction to Conte’s Tuesday comments were relatively well confined to Italian assets, they might serve as a reminder that the calm that quickly appeared to follow the resolution of the earlier impasse was premature and that eurozone politics remain another source of potential volatility this summer and beyond.

See: ECB cut back buying of Italian bonds in May, drawing Rome’s ire

And remember, in the event of a market meltdown, the ECB’s ability to squelch a rise in yields would be curtailed if Rome is at loggerheads with Brussels. The invention of the central bank’s Outright Monetary Transaction, or OMT, program following ECB President Mario Draghi’s 2012 pledge to do “whatever it takes” to preserve the euro was credited with bringing unsustainably high Italian borrowing costs down during the worst days of the debt fears. But the program would require Italy to agree to fiscal terms before it could be deployed.

Check out: 4 ways the ECB is helping prevent an Italian rerun of the euro crisis — for now

In the end, it could all turn on how Italian voters react to any showdown between Rome and Brussels—and that is something that only time will tell.

add Add to watchlist BX:TMBMKIT-02Y
BX : Tullett Prebon
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add Add to watchlist BX:TMBMKIT-10Y
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BX : Tullett Prebon
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IT : Borsa Italiana
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William Watts is MarketWatch's deputy markets editor, based in New York. Follow him on Twitter @wlwatts.

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