After a week of high drama, Italy late Thursday gained a new government formed of the League and 5 Star Movement. Friday morning, Italian bonds rallied hard and stocks rose 2.8%. But the Italian saga looks far from over.
If it seems odd that markets are cheering a coalition deal between two antiestablishment parties, the explanation is that snap elections have been avoided. These could have been framed as a vote on Italy’s membership of the euro, or at least given an even stronger mandate to populist parties. The naming of economist Giovanni Tria as economy minister, instead of euroskeptic Paolo Savona, is also being seen as somewhat reassuring, even if Mr. Tria has also been critical of the eurozone’s shortcomings.
Even after Friday’s rally, 10-year Italian bonds yield over 2.5%, still 0.7 percentage points higher than at the start of May. The gap to 10-year German bunds, at 2.14 percentage points, is far above its previous level. Markets have stopped panicking but are still alive to risk.
Uncertainty about what the new government will be able to achieve and the tone it will strike remains high. Its room for maneuver on tax and spending is limited by the country’s huge debt pile. Italy’s credit rating is under pressure, with Moody’s already reviewing its Baa2 rating for downgrade. A one-notch cut would leave Italy at the bottom of the investment-grade category. Some investors may greet the latest rally as a chance to sell.
Italy has stepped back from the brink, so markets have too. But the country, which faces some of the most entrenched economic problems in the eurozone, is now led by a novice government. The markets have given Italy’s new leaders a baptism of fire. More tests loom.
Write to Richard Barley at richard.barley@wsj.com