(Repeats item that first ran on Wednesday)
* Fresh elections could mark positive surprise
* Spark unwind of bearish bond bets
* Tensions with ruling coalition high
By Dhara Ranasinghe
LONDON, Nov 14 (Reuters) - With markets braced for a lengthy standoff between Rome and Brussels over Italy’s 2019 spending plans, investors see little that could change their gloomy view of Italian bonds other than a snap election that alters the makeup of the government.
Because markets are already positioned for further weakness in Italian debt - with a huge outstanding short position in government bond futures built up over the summer - prices are now most vulnerable to a positive surprise.
With neither the European Union nor Rome minded to change tack, the stability of Italy’s ruling coalition has become one of the few variables discussed by asset managers as a game changer. A snap election would raise the prospect of a centre-right coalition, seen as potentially more functional than the current government.
The tensions within the coalition of the far-right League and the anti-establishment 5-Star Movement were highlighted last week by it holding and winning a no-confidence vote, and also by its internal wrangling over removing time limits on trials.
Snap elections, seen as unlikely until at least after European Union parliamentary elections in May, remain a risk that could take investors by surprise.
Since the general election this March, Matteo Salvini’s League has gained ground in opinion polls, climbing to peaks above 30 percent while 5-Star’s support has faded.
“If Italy were to call a snap election, even with polls where they are at the moment, this would be relatively positive for Italian assets because most of League’s policies are budget friendly,” said David Zahn, head of European fixed income at Franklin Templeton.
“They want to cut taxes but they don’t have big spending plans like 5-Star and would probably partner with somebody else with a similar thought process,” he said. “From that perspective, you could see Italian bonds do relatively well on fresh elections.”
That’s significant because market pricing suggests investors largely expect bad news on Italy. A surge in the number of outstanding contracts in Italian government bond futures or open interest in recent weeks is one sign that markets are heavily positioned for more bond weakness.
That also means a development such as elections or a compromise on the budget forces a quick unwind of those bearish bets.
In May, a market positioned for further Italian bond gains had to adjust quickly as the formation of the League/5-Star coalition sparked fears about spendthrift policies.
Hopes for a breakthrough on the 2019 budget were dashed this week, however, with Rome sticking to its growth and deficit plans, setting the stage for a showdown with the EU.
Guggenheim Partners Global Chief Investment Officer Scott Minerd, a veteran investor who helped Italy restructure its debt after the European currency crises of 1992 and 1993, told Reuters there is an above-50 percent chance of Italy pulling out of the euro or another “catastrophic” outcome.
Italy has had over 60 governments since the end of World War Two, and political instability is part of the norm for investors there.
Recent developments suggest the threat of the new government falling remains alive. Rome last week called and won a confidence vote to tackle dissent within 5-Star over a contested security decree.
A separate dispute over removing time limits on trials was resolved after 5-Star’s Luigi Di Maio warned that the coalition would collapse if no agreement was reached.
Federico Santi at Eurasia Group said the collapse of the coalition and snap elections are unlikely any time soon as both parties are reluctant to take that risk.
“However, the stumble over the decree is the first sign the coalition is fraying at the edges, and confirms our view that the government is unlikely to last a full term,” he said in a note.
Georg Schuh, Chief Investment Officer for EMEA at DWS, told Reuters on Tuesday that if next May’s European parliament elections show support for populists, it is probable that Italy could call new elections.
“Then, if we have a coalition of the League and (conservative) Forza Italia, then this government could be a little bit more stable and less polarized,” he said.
Italy’s bond market is the worst-performing major euro zone debt market so far this year, with negative returns on 10-year bonds of 9.5 percent.
Its yield gap over German bonds is over 310 basis points , up from 125 bps just before May’s bond market rout, reflecting the extent of bearish sentiment on Italy.
A weak economy and the prospect of an end to European Central Bank stimulus are not helping.
UBP portfolio manager Mohammed Kazmi said most investors had taken a positive view going into the March Italian election and that was likely to be the case again in the event of a new vote.
“But to get to that stage, for new elections to be called, there is likely to be a lot of volatility first,” he said.
Reporting by Dhara Ranasinghe; Additional reporting by Helen Reid; Editing by Hugh Lawson