(Bloomberg) -- Concerns of a renewed showdown between Italy and the European Union are rippling through euro-area assets.
Italian bonds and stocks tumbled, leaving investors scrambling for the safety of German bunds a day after Deputy Prime Minister Matteo Salvini ratcheted up tensions by saying he would be prepared to see the country’s deficit rise above EU limits if it were to boost employment.
Fears over Italy’s deficit have resurfaced over the past week following a projection from the European Commission that the shortfall will exceed the bloc’s 3% limit in 2020. A battle between the nation’s leaders and Brussels roiled the nation’s bond markets last year before an agreement was finally reached. A strong performance by Europe’s populists at the European Parliamentary elections next week could embolden Salvini further.
“Italy’s yield spread was going to come under pressure over the summer on a protracted budget process, but the market is now front-running this scenario,” said Michael Leister, head of rates strategy at Commerzbank AG (DE:CBKG). “We will test 300-320 basis points versus bunds.”
Italy two-year yields surged 11 basis points to 0.79%, with trading volumes in bond futures reaching more than twice the 10-day average. The slide was precipitated by a block trade in short-dated contracts. The FTSE MIB Index of shares fell for a second day in three.
The slide in Italian notes spurred demand for German securities, with the 10-year bund yield falling three basis points to minus 0.10%, the lowest level since October 2016. Italy’s 10-year bonds now offer 287 basis points more, having widened 37 basis points this year.
Some investors will have been burned by the latest selloff. Italian bonds offer some of the highest yields in the euro area offering what’s known as carry -- effectively higher coupon payments received for just owning the bond. But those returns are eroded during volatile periods. Both NatWest Markets and Danske Bank A/S recommended long trades in segments of Italy’s bond markets in recent notes.
“Stay out of Italy,” said Jens Peter Sorensen, chief analyst at Danske, in emailed comments Wednesday.
Other investors favor the bonds of Italy’s neighbors, such as Portugal and Spain. Citigroup Inc (NYSE:C). extended its recommendation to buy Portuguese 10-year bonds versus their Italian peers for a second time, with the latest reports on the country’s deficit stoking another wave of selling pressure.
“On BTPs, we continue to target further widening to 300 basis points versus bunds in 10s on weak growth prospects and renewed politicization of the deficit,” wrote Citigroup strategists led by Jamie Searle.
The slide in Italy over the past week will have also been compounded by heightened fears over U.S.-China trade relations, according to Robeco Institutional Asset Management BV. President Donald Trump has given his Chinese counterparts a month to agree to a deal or face tariffs on all exports. Investors have shed riskier asset such as stocks and Italian bonds as a result.
“It’s not just idiosyncratic Italy risk that is driving bund yields lower but also the broader risk-off sentiment as evident in equities/credit risk markets,” said Martin van Vliet, a strategist at Robeco.