It was too good to last. A week ago, Italy’s government borrowing costs hit a two-year low; Italian share prices were 30 per cent higher than in July.

Investors saw the country reaping benefits of economic and fiscal reforms, its prospects underpinned by European Central Bank pledges to secure the eurozone’s integrity.

The mood snapped on Monday. An announcement at the weekend by Mario Monti that he would resign as prime minister– and confirmation that Silvio Berlusconi, his predecessor, was attempting to return to office on an anti-austerity platform– led to a sharp sell-off across Italian markets.

The FTSE MIB Italian share index was down almost 4 per cent at one point, before closing down 2.2 per cent. Banks were the biggest fallers. Italian 10-year bond yields, which trade inversely to prices, ended the day up 29 basis points at 4.8 per cent, the highest for more than two weeks.

The sudden turnaround “is a reminder that political risk is never far away from the eurozone”, says Julian Callow, senior economist at Barclays.

Like much of southern Europe, Italy is deep in recession, with economic indicators providing scant evidence of any early recovery. The country’s unemployment rate, at 11.1 per cent, remains below the eurozone average – but is increasing rapidly.

“Markets are wondering whether the current streak of pro-austerity electoral mandates – in Greece, Ireland, Portugal, and Spain, as well as in Italy – might end in 2013,” adds Mr Callow.

So far, however, the market shift appears to be more a correction after a post-summer rally on the back of increased political uncertainty in Italy than a fundamental reappraisal of eurozone threats.

“This is more the discounting of some bad news that has been hidden in all the optimism rather than a panicky mood,” says Silvio Peruzzo, European economist at Nomura.

The appointment of Mr Monti, a respected former European commissioner, as Italy’s technocratic prime minister in November last year was one of a series of steps that gradually rebuilt investor confidence in the stability of Europe’s 14-year old monetary union.

Mr Monti has pushed for market-friendly structural reforms and eurozone-wide initiatives to strengthen flaws in the currency area’s governance.

A few weeks after his appointment, the European Central Bank under Mario Draghi, a fellow Italian, launched the first of two offers of unlimited three-year loans to eurozone banks – a programme buttressed this summer by plans for ECB intervention in government bond markets if necessary to secure further the region’s financial stability.

The ECB’s action encouraged a renewed interest by investors in eurozone “periphery debt”, with Italy benefiting from favourable comparisons with Spain.

The perception was that Spain would be first in line for ECB intervention but that Spanish yields would have to increase further before Madrid accepted the central bank’s terms. In turn, that encouraged bets that the spread between the yields on Italian and Spanish sovereign bonds would widen.

By Monday, such trades had gone into reverse. “A lot of people didn’t anticipate the Italian elections coming earlier than was originally scheduled,” says Lyn Graham-Taylor, fixed income strategist at Rabobank.

At the same time, Mr Berlusconi has demonstrated that he has not lost his capacity to scare financial markets.

His final weeks in office in 2011 saw Italian bond yields rising sharply, despite intervention by the ECB, then headed by Jean-Claude Trichet, as his government reneged on reform promises. “If you are a non-Italian trader and all you read is the headlines, then you think, ‘Oh my, Berlusconi is back,” says Mr Graham-Taylor.

In fact, opinion polls show Mr Berlusconi has little chance of returning to office. Popular support is significantly greater for Pier Luigi Bersani, leader of the centre-left Democratic Party. Mr Monti could yet return to office.

In any event, substantial changes in Italian fiscal policy are unlikely, says Daniele Antonucci, senior economist at Morgan Stanley. “Markets will punish any slippage. Do you really think it is likely that pension reforms will be reversed?

“Traditionally, Italy has always tried to achieve a primary budget surplus [before interest payments], which is one reason why Italy’s economy has not grown very much. And one should not assume that the legacy of Monti’s government will disappear altogether. In one way or another, it’s likely to stay.”

Nick Nelson, global equity strategist at UBS, argues that Italy remains more attractive than Spain for global investors looking for exposure to peripheral eurozone equity markets.

Italy has not seen a housing bubble burst on the scale seen in Spain and its banks are further ahead in rebuilding their balance sheet strength. “You will get some wobbles because of the politics, but out of the peripherals, it would be our favourite market,” he says.

Nevertheless, many investors will remain wary about the country’s prospects. “Over 10 years you might make money in Italian bonds, but over the next year it looks tricky,” says Luca Paolini, chief strategist at Pictet Asset Management.

“They’re at the lower end of what we think is a fair yield range and there are a lot of political risks on the horizon.You would be better off buying Mexican bonds, which don’t have a lot of risks and have a higher yield.”

Additional reporting by Robin Wigglesworth

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