U.S. banks may be at risk from Italy's political turmoil

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The ripples from Italy's political turmoil are reaching American shores.

U.S. banks are coming under pressure in pre-market trading as the Mediterranean nation prepares for a fresh election that may become a de facto referendum on its membership in the euro currency union.

For U.S. financials, an unwelcome connection with their European peers may be resurfacing. The 63-session correlation between the daily change in the two banking groups strengthened in the aftermath of public protests over proposed Greek austerity measures in 2010. It also flared up around the numerous political flashpoints in the years that followed, episodes in which European financials were leading to the downside.

This relationship slumped to its weakest level since 2013 earlier this year as U.S. banks were buoyed by tax legislation and rising yields, but it jumped higher in May.

Macro conditions — rather than U.S. financials' ownership of Italian paper or perceived counterparty risk — appear to be the drivers of this unwelcome reunion in bank shares.

A flight to safety pushed the yield on the 10-year Treasury below 2.8 percent on Tuesday morning, narrowing the gap between two- and 10-year yields to nearly 41 basis points — the slimmest spread of this cycle. In 2018, relative returns for U.S. banks have closely correlated to the outright level of the domestic 10-year yield and, increasingly, the shape of the Treasury curve.

Curve flattening and the retreat in longer-term U.S. government borrowing costs caused the KBW Bank Index to fall 1.8 percent over its previous three sessions.

Bloomberg News