Politics unlikely to prevent a drop in EZ bond yields, says Capital Economics

Although there remains significant political uncertainty in many euro-zone countries, it is doubted that this will prevent most government bond yields from falling a bit further this year, according to the latest research report from Capital Economics.

Expectations for monetary policy often have the biggest influence on government bond yields. Nonetheless, politics can also be important. That has been the case in the euro-zone in recent years, particularly during the debt crisis roughly a decade ago.

That said, while political risk remains significant in many countries in the region, we doubt that this will be the main driver of government bond yields there in 2020.

Political risk remains an important consideration in Italy. After all, Matteo Salvini, the leader of the far-right League (Lega) party, is ahead in the opinion polls. While he toned down his eurosceptic views when he was in government, he has never hidden his antagonism towards the EU.

Nonetheless, Mr Salvini left office last year and his plan to trigger early elections failed. What’s more, his party lost a key regional election last month. Accordingly, the spread between 10-year Italian and German government bond yields dropped back down towards its lowest since the Global Financial Crisis.

The next general election in Italy is only due in 2023, and we doubt that the current coalition – which is primarily composed of the anti-establishment Five-Star Movement (M5S) and the centre-left Democratic Party (PD) – will collapse soon.

Polls suggest that the M5S would lose half its seats if elections were called right now. And the PD will probably want to take advantage of having a weak coalition partner to push forward its own agenda, the report added.

The only scheduled national vote this year is a constitutional referendum on 29th March on whether to reduce the number of parliamentarians. While the last such vote led to the resignation of former Prime Minister Matteo Renzi in 2016, that only happened because he had staked his future on the result.

"Overall, we doubt that politics will trigger a sharp rise in the spread between 10-year Italian and German government bond yields this year – as happened for instance when the M5S-League coalition was formed in 2018," Capital Economics further commented in the report.

Political uncertainty is quite high in France too. After the “gilets jaunes” movement that started in 2018, social unrest has continued in recent months with strikes against the government’s proposed pension reform.

But the legislation will probably still be approved, given the ruling Republic On The Move (LREM) party’s majority in Parliament. That would be presumably be welcomed by investors, as the reform would reduce the risk that France’s pension system puts pressure on its public finances, the report added.