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Italy Sparks Global Fear of Fresh Euro Crisis

Italy Sparks Global Fear of Fresh Euro Crisis

The Dow Jones Industrial Average dropped nearly 400 points and U.S. Treasury yields posted their largest daily decline in nearly two years as investors around the globe retreated from risk following signs of political upheaval in Italy.

Six years after the eurozone stepped back from the brink of a breakdown, a violent selloff in Southern European debt bled into broader financial markets, pushing investors toward the safety of the dollar and the Japanese yen, which rallied sharply.

Bank stocks led the market’s charge lower, reflecting fears that turmoil in Italian markets could spread throughout the eurozone, infecting the bloc’s banks and causing systemic issues in global markets.

The turbulence follows Italian President Sergio Mattarella’s decision Sunday to block the formation of a euroskeptic government, which revived longstanding worries about the broader stability of the eurozone. The move suggested a fresh round of elections that could strengthen the hand of antieuro forces, some of which seek to untangle Europe’s increasingly vulnerable union.

“There’s an existential threat hanging over the single currency if we head into more elections this summer; I don’t know how we get away from that now, given the scale of the financial implications,” said Kit Juckes, chief foreign- exchange strategist at Société Générale.

The Dow industrials dropped 1.6%, falling back into the red for the year. The S&P 500 declined 1.2% and the Stoxx Europe 600 closed 1.4% lower.

Financials were the hardest- hit sector in the S&P 500, sliding 3.4%, as bank shares tumbled. JPMorgan Chase & Co., the biggest American bank by assets, fell 4.3%, while Morgan Stanley , the smallest of the big banks, lost 5.8%.

The decline in longer-term U.S. bond yields also weighed on bank stocks, reflecting fears that a smaller difference between short- and long-term rates will dent profits. Yields on 10-year Treasurys fell to 2.772% Tuesday from 2.931% at the end of last week, the largest one-day yield decline since June 2016.

The euro, meanwhile, dropped to its lowest level against the dollar since July 2017, falling 0.7% to $1.1541 at 5 p.m. in New York. The WSJ Dollar Index rose 0.3% to 87.56, its highest closing value since November 2017.

Indicating the worry about Italy’s future, the government’s borrowing costs skyrocketed Tuesday. An auction of six-month Italian debt, which sold for a negative yield as recently as April, drew a yield of 1.213%, with lackluster demand from investors. The country’s two-year bond, which offered a negative yield as recently as two weeks ago, exploded Tuesday to as high as 2.69%.

Italy’s woes rippled across the eurozone, driven by investor worries that an exit by the bloc’s third-largest economy could force others out—as gauged by the spread between the 10-year government bond yields of each country and Germany’s. For Spain, these spreads widened to their biggest levels in a year, and for Portugal to the widest since September.

Amundi Asset Management , Europe’s top investor, with €1.4 trillion ($1.6 trillion) under supervision, had already cut most of its exposure to Southern European debt this year and is now “in a wait-and-see mode,” said Isabelle Vic-Philippe, its head of eurozone government debt.

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Dickie Hodges, a bond-fund manager at Nomura Asset Management, a firm with ¥50 trillion ($457 billion) under management, said he had removed all his holdings in Italian and Spanish debt and reduced Portuguese ones.

While neither believe the eurozone will break up, they expect the market turmoil to continue—making eurozone bonds unattractive for now.

The spread between different eurozone government bonds is seen by some as a key gauge of how likely the bloc is to survive, rather than of economic performance. Even after two Italian antiestablishment parties reached an agreement for a new government earlier this month, Italian debt was mostly unruffled.

It was the news that the proposed government might seek to break eurozone rules—and had even drafted plans to exit from the euro—that brought back echoes of the 2011-2012 sovereign-debt crisis, which European Central Bank President Mario Draghi is credited with ending with the promise to do “whatever it takes to preserve the euro.”

It is unclear how much bonds can sell off and for how long, investors said, because their worth ultimately depends on a political decision to keep the eurozone together.

Former IMF official Carlo Cottarelli arrives to talk to the media after a meeting with Italy’s President Sergio Mattarella at the Quirinal Palace in Rome on Monday. Mr. Cottarelli has been asked to try to form a new government. Photo: tony gentile/Reuters

“What is it you are trading? You don’t really know, because the implications of that tail-risk are very binary,” meaning either the euro holds together or it doesn’t, said Charlie Diebel, head of rates at Aviva Investors, which has £350 billion ($466 billion) under supervision.

Aviva had previously benefited from a rally in Italian government debt and was hoping for Spanish bonds to deliver a similar return. It has now slashed exposure to Southern European bonds.

In 2012, Mr. Draghi’s support managed to quell concerns that market turmoil could end up forcing a country, such as Greece, Portugal, Spain or Italy, out of the eurozone. But this time around, the risk is about a country choosing to leave, added Société Générale’s Mr. Juckes, so “it’s not clear what the ECB can do. It’s not really a liquidity issue.”

The banking sector is seen as especially vulnerable to write-offs in its large holdings of government debt, as well as people taking their money out of Europe.

Italy’s UniCredit SpA and BPER Banca SpA ended the day down by over 5%. , while Société Générale and Deutsche Bank dropped 2.9% and 4.6%, respectively.

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The politics-driven selloff comes as global-growth expectations have diminished, driven by disappointing economic data in the eurozone.

To be sure, fund managers who bet on the resolution of the eurozone’s 2011-12 debt crisis often reaped large rewards, as bond prices rebounded and yields dropped in the subsequent years. That has left some investors looking for opportunities to re-enter European government bond markets

“I think lots of active fund managers will be looking to take positions. People have thought that the ECB might stop its purchase program in September, that doesn’t seem so likely now,” said Darren Ruane, head of fixed interest at Investec Wealth and Investment.

“I would bet that a lot of bond fund managers are coming to that conclusion and looking for attractive entry points,” he added.

Write to Jon Sindreu at jon.sindreu@wsj.com and Mike Bird at Mike.Bird@wsj.com

Appeared in the May 30, 2018, print edition as ‘Italian Tumult Spurs Global Selloff.’

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