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After three years of relative calm, volatility has returned to sovereign bond markets in the euro area due to political uncertainty in Italy and, to a lesser extent, Spain point out analysts at Wells Fargo. According to them, more volatility should be expected in coming months as domestic and foreign actors in the Italian saga make their decisions.

Key Quotes:

“Sovereign bond markets in Europe generally have been quiet since the last Greek debt crisis in the summer of 2015. However, volatility has returned to “peripheral” bond markets (Italy, Spain, Portugal and Greece) in recent days due to political uncertainty in Italy and, to a lesser extent,   Spain. Although volatility could conceivably subside somewhat in coming days, a decline in yields to the levels that existed a few weeks ago in these markets does not seem likely in the near term.”

“Italians probably will be heading back to the polls this autumn, and political uncertainty in Italy likely will remain elevated until the next general election and perhaps beyond. Elevated levels of political uncertainty could spread to Spain, too, if Prime Minister Rajoy does not survive a confidence vote.”

“Italy has been able to stabilize its government debt-to-GDP ratio over the past few years due to sizeable surpluses in its primary budget balance. However, it will be difficult for the Italian government to bring about a meaningful reduction in its debt-to-GDP ratio in the absence of continued fiscal austerity due to the country’s inherently weak economic growth rate. But, it was frustration with the malaise in the economy, which is due in part to chronic austerity that led Italians in the March 4 elections to vote for populist parties that reject austerity.”

“Decisions that are made by political leaders in other European countries and by authorities at the ESM and the ECB will also play a role in the ultimate outcome of the current situation in Italy. To repeat, it is too early to make confident predictions about how the situation in Italy will ultimately evolve, but readers should be prepared for more volatility in the coming months as the actors in the Italian saga make their decisions.”