Mandatory Credit: Photo by CIRO FUSCO/EPA-EFE/REX/Shutterstock (9940093b)
Pedestrians are reflected in a puddle as they protect themselves from the pouring rain with umbrellas while walking in downtown Naples, southern Italy, 22 October 2018. Heavy rains had battered Italy from north to south on 21 October evening with even hailstorms been reported in Rome. Seen in background is the neo-classical Royal Palace at the Piazza del Plebiscito.
Bad weather in Naples, Italy - 22 Oct 2018

Matteo Salvini, the leader of Italy’s hard-right League party, has borrowed bond market language to create an ingenious new spin on the classic “enemies of the people” trope: the “lords of the spread”.

The spread in question is, of course, the difference between the yield on the Italian 10-year government bond and its German equivalent. This gap has soared to levels last seen half a decade ago as the budget stand-off between Rome and Brussels escalates.

Italy’s populist government has leapt on the bond market’s obsession with this risk measure to conjure up images of shadowy and hostile external forces. With his talk of not bending to the will of the “lords of the spread”, Mr Salvini is invoking the image of faceless bond traders trying to break the government.

While this message of defiance might play well with voters, the tragedy is that the real victims of the escalating spread are not bond traders. In fact, the men and women who buy and sell government bonds in the City of London will be relishing the volatility after years of anaesthetised markets driven by quantitative easing.

The pain really lies much closer to home, as each basis point added to the spread heaps pressure on Italy’s beleaguered banks.

This is because, despite the efforts of EU policymakers to break the so-called “doom loop” between eurozone countries and their banking systems, Italian banks still hold masses of their government’s bonds.

UniCredit, Italy’s biggest bank, has a seemingly healthy €45bn buffer of common equity tier one capital. But with an even bigger €55bn of Italian sovereign bonds on its books, it’s no wonder the bank’s chief executive said in May that the sell-off in the country’s government debt was “not justified”.

Italian banks are now, in effect, locked out of the mainstream funding markets and it is all but impossible for Italy’s weaker banks to raise capital at economic rates. As a result, Monte dei Paschi and Carige risk flunking agreements made with EU authorities to raise bonds that bolster their capital ratios this year.

The irony is that if the regulators do not let these banks off the hook, the London hedge fund managers that Mr Salvini demonises will extract a hefty price.

robert.smith@ft.com

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