Investors are just as likely to be over-optimistic as they are to be uber-pessimistic, and it looks like this is happening now when it comes to Italy.
A little more than a month before general elections, the spread of the Italian 10-year bond yield over German bunds has fallen to 133.2 basis points, a level not seen since Oct. 14, 2016, according to FactSet data. This is probably too low; yields on Italian bonds are likely to rise, either shortly before the election or after it, no matter what the result.
The good news is that the risk that Italy will cause the break-up of the eurozone has fallen sharply. The latest Sentix survey showed the headline eurozone break-up index fell to an all-time low of 6.9% in January. The sub-index for Italy was at 5.22%, showing that Italy remains a country which, in investors' view, still risks leaving the single currency area.
However, the likelihood of a populist-led government with an anti-euro platform emerging from the March 4 elections has dropped "significantly" over the past half year, according to Jamie Thompson, head of macro scenarios, and Nicola Nobile, senior economist at the Oxford Economics think-tank.
They pointed out that economic recovery and declines in immigration flows have eased economic and cultural stresses, while Italians' opinion of the euro has improved slightly. As a result, even the populists in Italy have softened their anti-euro rhetoric, realizing probably that insisting on leaving the single currency area is not the vote winner that it was thought to be.
The latest Eurobarometer survey of perceptions across the EU, published in December last year, showed that 59% of Italians were in favor of "a European economic and monetary union with one single currency, the euro."
The survey also showed that although most Italians (74%) perceive the situation their country as bad, their personal circumstances are beginning to improve. The percentage of people considering that their own personal job situation is bad has fallen by two percentage points to 31% in the autumn of last year from the spring.
Moreover, the percentage of Italians who believe the financial situation of their household is bad has fallen by three percentage points in the same period to a total of 34%, while the number of those who believe their financial situation will improve over the next year has edged up by two percentage points to 27%.
The leader of the populist Five-Start Movement (who insists his party is not populist), Luigi Di Maio, was in London earlier this week to meet with various groups of investors. His party leads in opinion polls, with around 28% of respondents saying they will vote for it.
Di Maio made it clear that his party would not seek a referendum on taking Italy out of the eurozone and the European Union, which could help explain the tightening of the spread of Italian bond yields over bunds.
"Our stance on Europe, on the euro, is that we want to remain part of the EU and the euro zone. We just want to change some economic rules. This should not scare businesses and investors, (that) we want to get some results for Italy and re-launch the EU," he told CNBC in an interview on Wednesday, Jan. 31.
Among the changes to the economic rules that he mentions, a worsening of the fiscal situation is very likely. This is something that investors have so far failed to price in, as they still focus on the relief caused by the populists' stalling in opinion polls and softening of anti-euro tones.
But, as Capital Economics European economist Jack Allen points out, "after all, most of the major parties have promised big tax cuts without offsetting reductions in spending. And most also want to loosen the EU's grip on Italy's budget. As a result, investors' concerns about debt sustainability will probably rise."
For the moment, the European Central Bank is still buying eurozone bonds, and a big part of those are Italian bonds. But with the ECB set to end its bond purchases in September, if the spread between Italian 10-year bond yields over German bunds has not already bottomed, it likely will soon. Investors should adjust their expectations accordingly.