Italian Events Spinning Away From Letta, Alfano Government

Political developments in Italy are happening faster than Prime Minister Letta can maneuver. The economy he is overseeing is the poster child of ECB President Draghi's assessment of a weak, fragile and uneven recovery in the euro area.

While Spain's Target2 imbalances are gradually declining, Italy's are edging higher. The economy is lagging behind Spain in the recovery as well. Spanish assets markets are outperforming Italy's.

This does not mean, though, that Italy's markets are doing poorly. Italy's 10-year bond yield is off about 18 bp this year so far, less than half the decline seen in Spain, but in line with the decline in French yields. Italy's equities are the best performer in the G7 so far this year. The FTSE MIB is up about 2%, while no other G7 market is positive, especially after last week's drop.

Earlier today, Italy auctioned 2-year zero coupon bonds at a record low yield of 1.03%, down a little more than 30 bp from the auction late last month. The lower yield did not discourage interest as evidenced by a higher bid-cover of 1.78 vs 1.48. Italy also sold 2108 inflation linked notes (at 1.39%). It raised 6.25 bln euros today. Italy will sell 8 bln of 6-month bills tomorrow and 5 and 10-year bonds on Thursday. Cash freed up by maturing issues and coupon payments in Italy and Spain are likely helping ensure solid demand.

Many observers attribute Italy's economic challenges to underlying political dysfunction. To this end, many are supporting the electoral reforms proposed by center-left's Renzi with support of Berlusconi. Polls suggest the reforms have the support of 60% of public. The electoral reform bill has its first hearing in the Chamber of Deputies tomorrow.

The electoral reform, however, increasingly renders the Letta government impotent. The reforms strengthen the power of the large political parties, which are essentially coalitions. It means that the rump of the center-right that split with Berlusconi under Alfano is living on borrowed time. And Letta's premiership turns to little more than a lame duck as soon as the electoral reform is approved.

Letta has wanted to reshuffle the cabinet given Renzi's victory as PD head. However, Letta is not fully in control of the process. Over the weekend, the Agricultural Minister resigned and she was a member of Alfano's faction. She had been accused of cronyism, but ultimately resigned in protest of the lack of support from Letta's government. There is also pressure on the Justice Minister to resign, though she survived a vote of no confidence in the middle of Q4 last year. Renzi favored her replacement then, but lost the debate to Letta then. It will be harder for Letta to resist the pressure now.