Critical next two days for European markets due to Draghi

European markets are bracing for another wave of volatility if Italian Prime Minister Draghi follows through on his pledge to step down on Wednesday, a day before the euro zone experiences its first rise in borrowing costs in more than a decade.

His exit will likely lead to early elections and bring turmoil to the country, a prospect that hit bonds and stocks last week.

Draghi’s departure would complicate the European Central Bank’s task of limiting the impact of higher interest rates at a time when markets are also jittery over the restart of a Russian gas pipeline.

For Jefferies and Pictet Wealth Management, it’s time to bet against Italian bonds. The firm sees a 50% chance of an early election, leading to questions about Draghi’s willingness to continue given the infighting in his coalition, even if he wins the confidence vote and stays on for now.

“If Draghi leaves, we will see a bigger impact on markets, especially spreads. We are still bearish on bonds in the region,” said an executive at Pictet Wealth Management.

While the political drama is not expected to stop the ECB from raising interest rates by 50 basis points this week – prompting a fresh selloff in European bonds – analysts say it risks delaying policymakers’ plans for a tool that will prevent fragmentation of the region’s borrowing costs as it increases.

Lagarde, the ECB president, is redoubling efforts to reach an agreement on the still-imperfect crisis tool ahead of Thursday’s meeting, sources said.

A larger rate hike may be part of the instrument negotiations.

“The ECB meeting on Thursday will be one of the most important in years and will probably have an impact on all markets. I think the reaction to a 50 basis point hike would be very negative – some gradual approach is needed,” he said. analyst at UniCredit SpA.

While that would hit bonds, such a rise would push the euro higher, according to Jefferies, to 1.04-1.05 against the dollar.

The currency has already rallied from a 20-year low a week ago on the prospect of faster rate hikes. Shares and bonds of the country’s biggest banks also recovered.

Draghi’s possible exit has complicated the ECB’s work because the instrument is intended to contain unwarranted rises in government bond yields, rather than softening the impact on the domestic machinery market. It may even harden the stance of more “aggressive” officials.

“Italian political developments will likely reduce the use of the tool in the short term as the ECB will not want to get involved in domestic political agendas,” said Franklin Templeton analyst.