EURO GOVT-Solid debt auction helps stabilise Italian bonds
* Italian debt prices steady after 7 bln euro bond sale
* Markets recover after wobbling on Berlusconi threat
* Spain yields stable, seen potentially outperforming Italy
By William James and Marius Zaharia
LONDON, Oct 30 (Reuters) - Italy's debt market shook off a bout of nerves induced by the threat of political upheaval with a solid bond auction on Tuesday that drew a line under a selloff seen the previous day.
Data showing the Spanish economy shrank slightly less than expected in the third quarter and selling of safe-haven German Bunds at technically important levels also helped to shore up debt prices across the euro zone's struggling states.
Investors' attention, previously fixed on Spain, had turned back to Italy after former Prime Minister Silvio Berlusconi threatened at the weekend to withdraw support for Mario Monti's technocrat government before elections in April. ID:nL5E8LR13F]
However, the selling seen on Monday stopped and Italy issued 7 billion euros of new five- and 10-year bonds at its lowest cost of borrowing since May 2011.
"Berlusconi is seen as a loose cannon. It shows that the political picture in Italy is still pretty clouded, but I don't think it is affecting Mr. Monti's rule for now," RIA Capital Markets bond strategist Nick Stamenkovic said.
Italian 10-year bond yields were 1 basis point lower at 5.00 percent, having risen 10 bps on Monday and about 25 bps in the last two weeks. Five-year yields dropped 6.5 bps to 3.83 percent.
German Bund futures settled 16 ticks lower at 141.54, having earlier risen to 142.00, a level at which traders noted renewed selling interest - indicating an aversion to pushing prices through the technical barrier of a round number.
Traders said activity tailed off throughout the day with U.S. bond markets closed due to giant storm Sandy which battered the country's east coast.
While the impact of Italy's internal political battles on bond markets was limited, pressure may increase on peripheral issuers in coming months as elections draw nearer, analysts say.
"With elections coming closer it will be more obvious that reforms have not been implemented ... and the real problem in Italy is politics. The periphery will suffer again," said Norbert Wuthe, rate strategist at Bayerische Landesbank.
Nevertheless, 10-year Spanish yields were steady on the day at 5.66 percent, and may even outperform Italian bonds despite the Spain's more-perilous debt problems.
Spanish debt is expected to rally sharply if Madrid activates the bond-buying support of the European Central Bank by requesting an external aid programme from the euro zone's rescue funds. While the government continues to resist such a move, markets still see it as inevitable.
That mean the 68 bps gap between 10-year Italian and Spanish bond yields could be set to narrow, with Italy expected to fiercely resist asking for a bailout that would allow the ECB to buy its bonds as well.
"People are going to be looking at getting those compression trades on between Spain and Italy now - if you leave it to the day when the ECB starts buying it'll be such a fast move that you won't be able to get on it," a trader said.
The spread between the two bond yields has already narrowed by around 60 bps since the ECB first hinted at its support in July.
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