Prospects of ECB easing drive Spain, Italy yields to record lows

Fri May 9, 2014 12:39pm EDT

* Euro zone bonds buoyant after ECB hints at June action

* Spanish and Italian yields at all-time lows

* Irish yields drop below UK in historic move

* Portuguese yields rise despite S&P credit outlook boost (Adds fresh quotes, updates prices)

By Emelia Sithole-Matarise and John Geddie

LONDON, May 9 (Reuters) - Italian and Spanish borrowing costs hit record lows on Friday in a broad-based rally in lower-rated euro zone bonds after the European Central Bank signalled it could deliver fresh monetary stimulus next month.

A Standard & Poor's uplift of Portugal's credit outlook to stable from negative gave a further boost to Lisbon as it prepares to exit its international bailout this month, although profit-taking took the gloss off an impressive rally. Moody's is due to at least follow suit after the market close while counterpart Fitch shifted its outlook to positive last month.

The focus remained on the ECB after President Mario Draghi gave his clearest signal yet on Thursday that policymakers might act in June to stem slowing inflation and bolster a fragile economic recovery in the currency bloc.

Spain and Italy, which two years ago were at the forefront of the euro zone debt crisis, badly need the recovery to gain traction to curb high debt levels.

Money market rates have tumbled, with the one-year Eonia rate - the most traded contract in the forward market - dropping to its lowest in a year as traders firmed up easing bets.

That gave fresh impetus to the rally in lower-rated bonds, which has been relentless this year after the ECB raised the prospect that it could embark on an asset purchase programme - quantitative easing - if inflation remained persistently low.

"The market is trading the ECB options, both of a rate cut in June and maybe further ahead of quantitative easing. That's why we are seeing the outperformance in non-core paper," said Alessandro Tentori, global head of rates strategy at Citi.

Yields on Italian and Spanish 10-year bonds hit record lows of 2.90 percent and 2.87 percent respectively, before paring those gains as investors squared off positions into the weekend, traders reported.

In a significant local milestone, Irish 10-year bonds dropped to lows of 2.65 percent, below the equivalent borrowing costs of the UK, a country that contributed significantly to its bailout four years ago.

"There is a sense of irony here because Ireland still owes the UK about 4 billion euros," said Owen Callan, a senior analyst at Danske Bank.

"But people need to look at rising yields in the UK as a healthy sign because of what it indicates about growth and inflation...in the euro zone it is the opposite."

Irish yields are now just 3 bps above US Treasuries , a differential that many think could reverse in the coming weeks amid expectations of looser ECB monetary policy.

While that ECB action is broadly expected to take the form of a rate cut or liquidity injection next month, some believe the final bullet of quantitative easing may never be needed.

"We do not fundamentally believe that disinflation will automatically lead to deflation in the Eurozone and we are not absolutely convinced that quantitative easing is how the ECB will address deflation risk going forward," said Franck Dixmier, CIO fixed-income Europe at Allianz Global Investors.

Dixmier said he was well positioned for a correction from current rates, holding a short position in German Bunds, the euro zone benchmark.

LIGHTENING UP

Portuguese 10-year yields initially fell 2 basis points to 3.44 percent, the lowest since early 2006, after S&P lifted the country's credit outlook early on Friday. The yields are a far cry from peaks above 17 percent hit at the height of the debt crisis.

The move was largely expected by analysts and mark a big turnaround in sentiment for a country which was seen at risk of defaulting on its debt just two years ago.

In what traders said was a sign that the latest rally in Portuguese bonds could be slightly overdone, however, early gains reversed, with yields finishing some 10bp wider on the day.

"In the European periphery we remain invested in Portuguese and Slovenian government bonds," said Scott Thiel, head of European Global Bonds at Blackrock.

"However, given their significant spread compression to German Bund yields in recent weeks and in light of excessive market expectations for imminent quantitative easing in the euro zone, we have reduced these positions." (Editing by Catherine Evans and John Stonestreet)

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