Political turmoil haunts Italy

Italian credits ensured that the Markit iTraxx Europe ended up wider losing ground in the first week of trading after the index roll.

And it will be no surprise to seasoned Italy observers that politics is driving the latest bout of negative sentiment. Silvio Berlusconi's Forza Italia party threatened to resign in unison if the Senate votes next week to strip the former prime minister of his seat in the upper house due to his fraud conviction.

If Forza Italia delivers on its promise, it would cause the collapse of Italy's fragile coalition government. Prime Minister Enrico Letta is battling to prevent this outcome, which would no doubt place further pressure on Italy's credit standing. The sovereign's CDS spreads widened 24bps over the week to 265bps, the widest level for over two months. Italian banks such as Unicredit (306bps, +22), and Intesa Sanpaolo (276bps, +20) were affected by the fallout, as were most Italian corporates.

A weak Italian auction on Friday underlined the economic consequences of political instability. The sovereign sold €6bn of debt maturing in 2018 and 2014. Demand was insipid and thought to be driven by dealers rather than real money investors. The markets will be watching developments over the weekend with interest.

They will also be keeping a close eye on negotiations in Washington, where the drama around the US debt ceiling could come to a climax. So far, the deadlock in Congress had had little impact on risk appetite, though there has been some modest widening in US sovereign CDS spreads. This suggests that the markets are placing a low probability on a government shutdown. We will find out if they are right soon enough.

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