"A political vacuum could send Italian spreads above 250bp without help by the ECB, and add pressure to the euro"

Above: File image of Mario Draghi. © European Central Bank, reproduced under CC licensing.

Italian Prime Minister Mario Draghi has tendered his resignation after populist coalition partner Five Star withdrew its support in a confidence vote, a move that created ripples in bond and currency markets.

5 Star had grown frustrated with what they say is Draghi's unwillingness to provide more fiscal support to Italians struggling under the surging cost of living.

President Sergio Mattarella however refused his resignation, tasking Draghi with finding a route forward.

Analysis from ING says the announcement might have helped propel the Euro lower against the Dollar on Thursday where a low of 0.9952 was printed.

The Euro's subsequent recovery does however suggest the market is not yet too concerned by the political uncertainty.

Indeed, Italian political uncertainty of this kind is relatively common and for the most part the Euro is nonplussed.

But, this crisis comes at a time of radical change in the Eurozone's financial landscape as the European Central Bank (ECB) looks to step back from offering its unlimited support to the bloc, something Draghi himself introduced when he was head of the central bank.

The Italian political uncertainty inevitably lead investors to demand a greater premium for holding debt issued by the Italian government with the yield paid on ten-year bonds rising 5.6% on the day.

This contrasts to a flat performance on German yields; it is this divergence in the debt constraints placed on various Eurozone countries the ECB is at all times desperate to avoid.

Typically the ECB will buy Italian bonds to suppress the yield, but this becomes tricky when you are trying to exit the bond market space and raise interest rates to get on top of inflation.

"The 10Y Italy-Germany spread back to the 200-250bp 'danger zone' where the ECB has intervened verbally in the past, piling pressure into next week's meeting," says Antoine Bouvet, Senior Rates Strategist at ING.

He adds that without a stable government and a pledge to abide by some sort of conditionality, the ECB can scarcely justify buying more Italian bonds.

ING strategists say the biggest threat to the Euro would come in the event of a political vacuum opening up, most likely under the scenario of a snap election being called.

"A political vacuum could send Italian spreads above 250bp without help by the ECB, and add pressure to the euro," says ING.

Draghi could yet still negotiate a compromise with the 5 Star Movement that ensures his government stays in place.

He could also readjust his cabinet to allow for another, albeit smaller, majority in parliament as other parties are brought into the fold.

Alternatively, another Prime Minister could be agreed on by the existing parties to break the current impasse.

There are therefore options available and the outright chaos required for a material blowout in Italian bonds and the Euro looks to be some way off as a result.

"Gas crunch fears and a hawkish repricing of Fed expectations should remain much more relevant drivers in the near term," says Francesco Pesole, FX Strategist at ING.