Italian bonds and stocks were sent sharply lower on Wednesday, with investors spooked by a draft proposal from Italys two main populist parties to radically change the countrys relationship with the rest of Europe.
The 39-page draft, obtained by Huffington Post Italia and published late Tuesday, outlined plans by the 5 Star Movement and the League to ask the European Central Bank to forgive 250 billion ($294 billion) of Italian debt and renegotiate Italys contribution to the European Unions budget. The proposal also included a suggestion for new rules within the eurozone to allow member states to leave the monetary union.
Both the 5 Star Movement and League have previously floated ideas of a Brexit-style referendum on Italys EU membership, but dialed back their euroscepticism ahead of the countrys March election. Thus the draft presented a more drastic agenda than expected, raising fears Italy could end up on a path to leave the euro.
However, since the leak on Tuesday the two parties said the draft was an old version that has been modified considerably, and they had decided not to call into question the single currency, according to media reports.
Even so, traders were worried about by the developments. The euro
dipped below $1.18, buying $1.1781 compared with $1.1837 late Tuesday in New York.
The FTSE MIB index
Italys benchmark stock index slumped 2.3% to close at 23,734.22, suffering its biggest daily drop since March 2, according to FactSet data.
The yield on 10-year Italian government bonds
rose 17 basis points to 2.112%, trading around its highest level since January. The higher yield signals investors are becoming more nervous about the countrys finances and in turn demanding a higher premium to buy the bonds.
The new government, made up of political outsiders, will only add to the sense of chaos in the country, said Boris Schlossberg, managing director of FX Strategy, in a note.
For now, the overall growth in the region is papering over the brewing conflict, but if the economic situation in the region slows much further, the new Italian government, unencumbered by political norms, could wreak havoc in the EZ and usher in a new crisis in the region, he added. EZ refers to the eurozone.
Italy has been stuck in a political deadlock since the general election on March 4 produced an inconclusive result. The antiestablishment 5 Star Movement and far-right League party came in first and third, respectively, but were up until last week unable to agree on a coalition program to create a government.
Earlier in May, Italian President Sergio Mattarella raised the specter of new elections after a last-ditch effort to persuade the political groups to bridge their differences failed. Mattarella urged the parties to instead back a caretaker government that could lead the country until the end of the year and approve the budget.
A center-right coalition, led by the anti-immigrant League and including Silvio Berlusconis Forza Italia, emerged as the largest grouping with around 37% of the popular vote in March. But it was unable to agree on a program. The 5 Star Movement emerged as the biggest party, but was seen as unlikely to enter into alliances.
Then, before a short-term government was approved, the 5 Star Movement and the League on Sunday said they had agreed on the outlines of coalition program.
It seems euro leaders were too quick to congratulate themselves on a job well done when defeating populists last year, said Craig Erlam, senior market analyst at Oanda, in a note. European officials may have a massive job on their hands that makes Brexit look more straight forward, he added.