Fears that Italy will leave the eurozone and trigger a lira-fuelled inflation spike have disappeared altogether from market pricing, replaced now by worries over low inflation and growth in the eurozone’s third largest economy.

With the EU this week saying it will not penalise Italy for breaching debt rules after Rome appeared keen to avoid such sanctions. Italy’s inflation-linked bond market now suggests investor fears of a euro exit have evaporated.

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Italy has one of the most liquid inflation-linked bond markets in the eurozone, issuing debt linked both to eurozone and Italian inflation.

One way of hedging so-called ‘Quitaly’ risk last year was to buy Italian debt linked to local inflation over eurozone inflation on the basis that a return to the lira would result in significant devaluation, and therefore high inflation.

This trade was particularly popular last summer, when concerns were high that anti-euro parties would come to power and try taking the country out of the bloc.

But with the current coalition government proving more placatory than had been expected, and with Deputy Prime Minister Salvini showing no signs of trying to force a general election to secure sole control for his anti-euro League party, the trade has switched.

“The fact that Italian-inflation linked bonds aren’t reacting as dramatically suggest that people think Salvini won’t force an election and markets are quite sanguine about the fear of Italy leaving the euro,” said Colin Harte, at BNP Paribas Asset Management.

Reuters

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