Frederik Ducrozet, Pictet Wealth Management: Following a confidence vote in the Italian Senate on Thursday, which the government won but without the support from coalition partner M5S (Five Star), PM Mario Draghi offered his resignation.

Italian President Mattarella refused Draghi’s resignation, and asked him to report to parliament and assess the situation. The situation remains fluid, but Draghi is likely to have a round of talks with coalition parties, and he could then call for another confidence vote next week.

There are three possible scenarios:

1. Draghi could stay after winning the confidence vote. Note that the underlying tensions have been going on for a long time with M5S but they are not insurmountable, mostly linked to fiscal support measures as a response to the energy crisis. If Draghi stays, the whole cabinet would likely have to back him.
2. If Draghi leaves, the President may ask someone else to form a caretaker government, either a technocrat or a politician (the name of finance minister Daniele Franco has been floated) which could carry on until next year.
3. If this option fails, the parliament would have to be dissolved and early elections to be called within 70 days, before H1 2023 as initially scheduled. Early October would be a possible date, although Italy never held elections in the Autumn at a time when the budget needs to be approved.

The political landscape looks as fragmented and uncertain as ever. The far-right eurosceptic FdI (Brothers of Italy) are ahead in the polls, followed by the Democratic party, while the populists Lega and M5S are lagging and falling. It may not be in their interest to call early elections, hence our view that the more likely scenario remains for a government to buy time until next year’s election. Either way, a coalition would have to be formed, and the big question is whether FdI will be part of it, which would be a major risk from a European perspective.

Italy will have to agree on a budget and send their plan to Brussels by mid-October. The government will also have to clear some final milestones to be eligible to the next RRF tranches (some €20bn+ in H2 2022).

>> What does it mean for the ECB? More uncertainty, but also an opportunity <<

Italy is adding another layer of risk to an already very difficult situation, but our impression is that the bar is high for the ECB to deviate from its plan.

We still expect the ECB to hike rates by 25bp in July while hinting at a larger move in September unless the inflation outlook improves, as confirmed by Governing Council member Olli Rehn today.

The anti-fragmentation tool (Transmission Protection Mechanism) is expected to be unveiled at the 21 July meeting. There is a risk that some details are missing, but market expectations don’t look overly optimistic and we still expect the TPM to be bold, flexible, and credible enough to prevent a sustained widening in peripheral bond spreads over the medium term.

Importantly, we expect the TMP to be unlimited in size, with limited conditionality based on the reforms agenda embedded in the disbursement of the NGEU funds. Targeted maturities could be somewhat longer than under the OMT, say up to 5 years, while the criteria for interventions are likely to remain vague enough for the ECB to retain a high degree of discretion. Last but not least, asset purchases are likely to be sterilised although we view this decision as politically motivated more than anything else, against the backdrop of €4,500bn in excess liquidity.

Meanwhile, the ECB has started to apply flexibility to the reinvestments of maturing PEPP bonds on July 1st. Looking ahead, we wouldn’t rule out more radical options including larger deviations from capital keys for longer, or even a transfer of flexibility from PEPP to PSPP reinvestments.

Needless to say, Italy’s political turbulences aren’t helping. But this crisis could also provide the ECB with an opportunity to clarify its strategy and make the TPM more acceptable to the hawks. A self-inflicted political crisis in Italy is the textbook case of a situation where the ECB should not intervene. ECB members are likely to unanimously agree that a necessary condition for a member state to be eligible to the TPM will be for the government to comply with the European reforms agenda. In other words, the ECB may unveil a bold anti-fragmentation tool while putting the ball back in Italy’s court.

Regarding the TPM, the other important trade-off will be that the more credible the backstop, the lower the chances that the ECB has to use it, and the higher it may increase policy rates. At least that is the plan.

BTP are likely to remain under pressure in the near-term until we get clarity on the political front. Mario Draghi will be out of the equation, either very soon or by early next year. However, another silver lining supporting BTP will be the favourable supply dynamics in H2. The Italian Treasury has completed nearly 60% of this year’s funding objectives and with large redemptions looming in coming months, net supply is projected to be slightly negative for the remaining of the year (unless fiscal spending increases dramatically). This is in sharp contrast with all other large member states which face positive net supply of government bonds after the ECB stopped its net asset purchases in early July.
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