Political uncertainty in Italy has unhinged world markets, raising the specter of a euro crisis that could ripple across the global economy and even force the Federal Reserve to slow its rate hiking plans.

Several strategists say there is little chance the euro zone’s third largest economy will move to leave the single currency, creating a continent-wide crisis of confidence. But internal chaos and a new election could make for a rocky summer for markets and even put a dent in European economic growth.

Italy moved to the foreground as the latest source of angst for markets, after a weekend of drama where President Sergio Mattarella Sunday blocked the formation of a government that would have been decidedly against the euro.

The anti-establishment 5 star Movement, Italy’s biggest party, and the far-right League party picked euro-critic Paolo Savona as their economy minister. The two parties, both critical of Europe’s single currency, had won more than half the votes in March’s parliamentary elections. Mattarella vetoed the choice and instead asked Carlo Cottarelli, a former IMF official toform a temporary government, but both parties object to him and a new vote is now expected in late July.

The euro sank, losing 0.7 percent Tuesday to $1.1540, and investors dumped Italian bonds while seeking safety in U.S. Treasurys and German bunds. The 2-year Italian yield briefly snapped above 2.73 percent, a sharp move from just 0.48 percent on Friday and a negative yield earlier this month.

Global equity markets slumped, with the Dow tumbling more than 450 points. Banks led the selloff, and the S&P financial sector declined more than 3 percent. In Europe, yields on Italian bank debt spiked as bank shares sold off.

Chris Rupkey, chief financial economist at MUFG Union Bank, said a rash of recent data has already raised concerns about European growth. “This could be the straw that breaks the camel’s back in the case of prospects for Europe. It will spill over into the U.S. They won’t buy as many of our imports,” he said. “When world economic growth has been threatened in the last three years, it was a concern. It hurts confidence on the economic outlook for the U.S. There’s always spillover affects…Given what we know right now, I would not be comfortable rushing out and forecasting a rate hike in September.”

But Rupkey also said the markets are reacting to news that occurred over a three-day holiday weekend in the U.S. and may not be as turbulent in upcoming sessions.

“It’s not a full-blown European sovereign debt crisis yet. For one thing, the Italian 10-year yield is a little over 3 percent. Back in 2012, it was at 8 percent. It’s not the same situation yet. I’m sure many American traders wish that Europe in general would stop having these mini referendums on whether the euro is going to survive,” said Rupkey. “It’s going to be really dragged out. I don’t think we can trade on this every day. I don’t think 10-year yields in Italy are going to go higher and higher every day, waiting for that vote. The focus is going to shift back pretty quickly to the U.S., which is employment and wage data on Friday.”

For some traders, the Italian political crisis is deja vu, to the Greek debt crisis which wound down three years ago after fanning fears that the whole financial and economic fabric of the euro zone could unravel.

“The chaos in Europe is pushing down U.S. interest rates so money is flowing to the U.S., fleeing Europe, making people think, that [with falling interest rates], coupled with the rising dollar, that the Fed responds by maybe having second thoughts about the trajectory of Fed policy,” said said Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman. “It also is a risk to the real economy because Europe’s a big trading partner.”

The Federal Reserve, driven by a stronger U.S. economy, is on track to raise interest rates for a second time this year at its meeting June 13. The Fed has forecast three hikes for this year, but the markets had been expecting an added hike in September, in addition to December.

“The Fed is going to raise in June, raise in September and then they’re going to play it by ear,” said Peter Boockvar, CIO at Bleakley Advisory Group.

The U.S. 2-year Treasury yield, the most sensitive to Fed rate hikes, slipped to 2.38 percent, after touching 2.60 percent recently. The 10-year dipped to 2.82 percent from 3.12 percent just several weeks ago.

Chandler said he does not expect a new Italian government to push to exit the euro, though it could threaten other measures. Italy is the biggest debtor in the euro zone, with 2.3 trillion euros in debt, or 132 percent of GDP last year. That is double Germany’s level and well above the 87 percent of the euro zone.

“Their tactics would be to make some demands like ‘let’s cut taxes. Let’s use our t-bills to pay down our arrears…let’s keep challenging the EU,'” Chandler said. “That’s the back door to leave. You place demands on the EU.”

He said the next coalition government could have a list of proposals to challenge the existing rules of the EU. “That’s why despite what their lips say, ‘we’re not looking to leave immediately,’ what it increases is the stress on the system, the demands they are placing,” Chandler said.

But the likelihood Italy leaves the euro are “slim to none,” he said.

Spain is another worry markets, with a vote of confidence later this week on the administration of Prime Minister Mariano Rajoy because of a campaign finance scandal. That could force a new election for that country, which has already seen a deep divide over the Catalan region’s wish to split from Spain.

“The outcome in Italy is hard to see as an investment friendly outcome It’s much easier to see an investor friendly outcome in Spain. Spain is bad but Italy is a lot worse,” he said.

Chandler said one outcome in the next election is that Silvio Berlusconi, former Prime Minister, could run for office again. A court ruled that the three-time prime minister may again seek office, after being banned because of tax fraud for more than five years. Berlusconi has been supportive of a ‘parallel’ currency to the euro, Chandler said.

Also unclear is how the European Central Bank will respond to the turmoil kicked up by Italy, and some strategists say ECB President Mario Draghi would be sure to retain stimulus as needed. The ECB is expected to announce in September that it will put aside its asset purchases, but if Italy’s woes spill into the broader economy, that could be in doubt.

“He’s completely lost control of the Italian bond market in two weeks,” said Boockvar. “I think he’s going to do his best to verbally calm nerves but as far as legally using his balance sheet to help, I don’t see what he can do.”

But some traders appear to see the Italian situation as enough of a red flag to slow the Fed, particularly after the U.K. Brexit vote led to a market correction.

“The market is still pricing in a Fed hike for next month. It’s already in the cards. Why would the Fed not raise interest rates, given the kind of economic data we expect this week?” said Chandler. “Where I really see this having affect is on the back end. The September hike.”

Robert Sinche, chief global strategist at Amherst Pierpont, does not see enough damage from Italy to slow the Fed.

“I think this will be a lot of noise, but I’ve seen this movie three or four times before. Italy stays in [the euro zone], and life goes on. There could be a little more uncertainty over the summer. They’ve realized that which is why they pushed up the election to late July/early August,” he said.

“The ECB has been notoriously quiet because I think they like the signals the market is sending to Italy on the type of fiscal policies they’re talking about,” said Sinche. “I think we’ve had this spasm of risk off and in another couple of days we’ll be focused on some other bright light that comes along. I think what we’re seeing now is really a lot of liquidations of shorts in the bond market that were feeling pretty confident in Fed hikes and inflation.”

Source: Investment Cnbc
Here's why markets are so scared of the latest Italian political drama