Italian Bonds Tumble, Triggering Goldman “Contagion” Level As Political Crisis Erupts In Spain

When it comes to the latest rout in Italian bonds, which has continued this morning sending the 10Y BTP yield beyond 2.40%, a level above which Morgan Stanley had predicted fresh BTP selling would emerge as a break would leave many bondholders, including domestic lenders with non-carry-adjusted losses…

… there has been just one question: when does the Italian turmoil spread to the rest of Europe?

One answer was presented yesterday by Goldman Sachs which explicitly defined the “worst-case” contagion threshold level, and said to keep a close eye on the BTP-Bund spread and specifically whether it moves beyond 200 bps.

Should spreads convincingly move above 200bp, systemic spill-overs into EMU assets and beyond would likely increase. Italian sovereign risk has stayed for the most part local so far. Indeed, the 10-year German Bund has failed to break below 50bp, and Spanish bonds have increased a meager 10bp from their lows. This is consistent with our long-standing expectation that Italy would not become a systemic event. That said, should BTP 10-year spreads head above 200bp, the spill-over effects onto other EMU sovereigns would likely intensify.

Well, as of this morning, the 200bps Bund-BTP level has been officially breached. So, if Goldman is right, it may be time to start panicking.

Ironically, almost as if on cue, just as the Italy-Germany spread was blowing out, a flashing red Bloomberg headline hit, confirming the market’s worst fears:

• SPANISH SOCIALISTS REGISTER NO-CONFIDENCE MOTION AGAINST RAJOY.

This confirmed reports overnight that Spain’s biggest opposition party, the PSOE or Socialist Party, was pushing for a no-confidence motion again Spain’s unpopular prime minister. The no-confidence call follows the National Court ruling on Thursday that former Popular Party officials had operated an illegal slush fund, as a result of which nearly 30 people were sentenced to a total of 351 years in prison.

And while Spain’s anti-establishment party Podemos has already called for a Raoy no-confidence vote, the Socialist Party joining that call makes this outcome more likely, but would still need the support of one more party as just these two do not guarantee Rajoy’s exit, and a Rajoy overthrow depends on the participation of market-friendly party Ciudadanos, Spain’s 4th largest party.

Well, following this headline, Rajoy’s political future suddenly appears to be over as Ciudadaons, which holds the balance of power in Spain’s government, just gave the PM a thumbs down.

• CIUDADANOS WILLING TO BACK NO-CONFIDENCE VOTE AGAINST RAJOY

Immediately after the news, the selling started with Spain’s 10Y bonds erasing day’s gains, with the yield now higher by 4bps on the day, while Spain’s Ibex slumped, falling as much as 0.9%.

Which means that, while independent of the Italian bond rout, Europe’s political crisis may very soon have not one epicenter, but two: Rome and Madrid.