Despite the uncertainty surrounding the upcoming Italian elections yields on Italian bond markets have continued to fall as investors become more relaxed about diminishing risks of a potential euro break-up.
Ever since ECB President Draghi uttered those now immortal words "and believe me it will be enough" last July with respect to ECB actions to keep a lid on bond yields with the ECB's OMT program, pressure has eased on borrowing costs across the board with spreads between Italian and German 10 year bonds narrowing to their lowest levels since August 2011 earlier today.
The slow decline in yields over the past few months has been pretty much one way, apart from a brief spike in early December, even allowing for the initial uncertainty caused by Italian technocrat PM Mario Monti's decision to step down early as a result of the loss of support for his on-going reform program.
The return of former PM Silvio Berlusconi to the political stage appears to be being treated as "white noise" by the markets for the moment, especially given that the current poll leader Pier Luigi Bersani has stated that he intends to stick by the current reform program, if he is elected.
The decision by Mario Monti to run as a centrist candidate has also introduced a new element into the process, in that his presence could actually split the vote in a way that could actually see Berlusconi hold the balance of power.
All the noise so far has been about Berlusconi and Monti as they fire off verbal grenades at each other, while poll leader Bersani has looked on from the side-lines.
Italian 10 year bond yield
Berlusconi's pledge to try and create a blocking caucus in the Senate appears for now to be being treated as a low probability by markets; however there remains the very real risk that post-election the current fall in yields could see a sharp reversal.
The state of the Italian economy is certainly not helping the pro-European cause with Italian unemployment continuing to rise and youth unemployment at 37.1%, a record high. GDP continues to contract and consumer sentiment remains subdued.
For now the "Draghi Put" is keeping investors and markets on-side, as can be seen by the narrowing of the BTP/Bund spread shown below to its narrowest levels since mid-2011.
BTP/Bund spread chart
The direction of travel with respect to borrowing costs for Italy remains firmly down and the spread looks like it could well come in further after breaking below the levels seen in the second quarter of 2012. It is important to remember that the lows seen early last year were as a result of the second LTRO, and that subsequently didn't turn out so well.
As things stand the ECB's OMT pledge has not yet been tested, however that could well change if unemployment continues to rise and the Italian election returns an inconclusive result.
Markets are currently assuming a positive result from the forthcoming polls which, on the face of it appears, somewhat optimistic. Any outcome other than a clear Bersani win is likely to see further reforms very difficult to implement and see pressure on Italian yields return.
For now the markets appear to be pricing in a positive outcome, with spreads at 260 points. The current move could see spreads come in to 200 points, the 2010 highs, but that could well change as polling day approaches.
The flip side of falling bond yields in Italy and Spain has been the correlation these yields have had with the performance of the euro currency. When yields have risen the euro has fallen, however the recent weakness in these yields has seen a strong rebound in the value of the single currency.
Given the economic dynamics at play in Italy and Spain a stronger currency is the last thing these two countries need. In a sense the normalisation in financial markets could have the unintended consequence of making it much harder for Italy and Spain to regain competitiveness, and trigger off more unrest in these countries, over the coming months.
The above 7% peaks seen in Italian and Spanish yields last year also coincided with the 1.2050 lows in EURUSD. Since those euro lows, yields have dropped sharply, sending the euro higher.