While Italy’s political situation enhances the prospect of a so-called fat-tail event—the election of an Italian government that could threaten or potentially push Italy to exit the euro, with all the fallout (European recession, increased market volatility, etc.) that would come with it—it seems a little early to worry about such an outcome.
For one, a tail event by definition is a low probability (albeit a costly one if does come to pass). For another, it appears Italy may be working toward an election or, at the least, the current parties may be able to cobble together a government. But even if Italy were to move to exit the European Union, it would be a lot like Brexit—that is, it would take a long, long time. The market is not about to price in an event that may be two or three years down the road—if at all.
That may be why the global equity markets, led by Italy, rallied strongly today while bond prices fell, reversing to some extent yesterday's action. We’ll get more clarity in the next few weeks and months but in the meantime, a worst-case scenario isn’t happening anytime soon and many events could potentially intercede in the interim to diffuse the situation. The European Central Bank could stick to its taper plan but get more dovish on policy signaling about rates. Or there could be additional bouts of market discipline (wider Italy spreads to German bunds; a plunge in Italian equity prices, etc.) to send messages to Italian political actors (parties and voters) to get their act together. Italy, after all, has a history of settling down after bouts of political histrionics. It may well be it’s no different this time around. We’ll keep you posted.