Traders Are Hedging Risk Italy Leaves Euro After Draghi Resigns

(Bloomberg) — The collapse of Italy’s government is awakening a dormant threat in European bond markets.

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Credit-default swaps suggest investors are starting to worry about a future administration pulling or crashing the nation out of the euro. They are buying newer swaps, which offer more protection against such an event, driving up their premium to older swaps to the highest since 2018 on Thursday.

That came after Italian bonds slid in the wake of Prime Minister Mario Draghi resigning, which opens the door to snap elections that could bring in a more euroskeptic or less fiscally responsible government. The debt sold off further after the European Central Bank hiked borrowing costs more than expected, with a new tool to stop unwarranted yield spikes failing to stop the rout.

Draghi Resigns as Premier, Leaving Italy Politically Adrift

The difference in the CDS contracts is because those written after a 2014 overhaul of rules in the wake of the euro-area debt crisis were designed to offer greater protection against redenomination. This so-called ISDA basis in five-year swaps widened as much as 14 basis.

It reflects Italy’s “unsteady political backdrop alongside the European Central Bank’s imminent stimulus withdrawal,” said Richard McGuire, head of rates strategy at Rabobank. “The fact the ISDA basis is wider than at any time since 2018 highlights the latent spread widening pressures that Italy is facing.”

Seasoned traders are familiar with hedging against euro-zone break-up risks. Political turmoil has seen the ISDA basis in Italy flare up on several occasions, while French swaps also diverged in the run-up to the nation’s 2017 presidential election. The name of the spread refers to the International Swaps & Derivatives Association, which organized the contract overhaul.