Italian, Spanish bond yields rise as pre-election jitters set in

Mon May 19, 2014 9:06am EDT

* Investors take profits before European elections

* Irish bonds reverse gains after Moody's upgrade

* Portugal exits bailout but reform risks remain

* Greek sell-off halts but politics fragile (Adds fresh quotes, updates prices)

By John Geddie

LONDON, May 19 (Reuters) - Peripheral euro zone bond yields pushed higher on Monday, as investors took profits on recent price gains before potentially destabilising European elections.

Italian and Spanish yields reversed an initial dip, rising 10 basis points to highs for the day of 3.06 percent and 3.17 percent, respectively.

Traders said investors were concerned that votes for anti-austerity, euro sceptic parties would thwart reform efforts.

"The market has been pricing in that these reforms efforts will follow through, and if the outcome of the elections is seen to reduce that probability, then people will think twice about holding those positions," said Michael Michaelides, rates strategist at RBS.

Investors are closely watching Greece, where votes for opposition parties may weaken the already fragile ruling coalition and potentially pave the way for national elections.

Syriza, an anti-bailout, leftist party, performed strongly in the first round of local elections on Sunday, an indication that they could fare well on the European stage.

In Italy, a showdown between Italian Prime Minister Matteo Renzi and the anti-establishment movement of comic Beppe Grillo could also decide the future of the government.

Pre-election jitters have been slow to materialise, with expectations of European Central Bank intervention underpinning a rally in peripheral debt over the last months.

"Everyone has gotten very, very long since the start of May with a lot of peripheral supply and expectations that the European Central Bank will give some fresh stimulus in June," said Owen Callan, a senior analyst at Danske Bank.

The uncertain political landscape, coupled with weak EU economic data last week, has led to profit-taking among more speculative buyers like hedge funds, said Callan.

Interest from real money and domestic investors, however, is likely to stem a more pronounced yield rise, with the ECB expected to introduce cuts in all its interest rates and targeted measures aimed at boosting lending to small- and mid-sized firms (SMEs) at its next meeting.

A programme of asset purchases, known as quantitative easing, is also on the cards, although some think it may not succeed in keep borrowing costs down. [ID: nL6N0O159A]

QUICKLY ERASED

Even Irish bonds, which were upgraded two notches by Moody's late Friday, were unable to perform. A dip in 10-year yields at the open was quickly erased, with yields climbing 4 bps on the day at 2.73 percent.

Moody's upgraded Ireland's credit rating from Baa3 to Baa1, bringing its view into line with the other two main ratings agencies.

Confirmation of Portugal's exit from its 78 billion euro ($107 billion) bailout also failed to win over risk-averse investors.

Lisbon took back control of its public finances from the European Commission, European Central Bank and International Monetary Fund at the weekend, with its budget in much better shape and borrowing costs at eight-year lows.

Portugal has chosen not to apply for a precautionary credit line, a move that will focus investor attention on a mixed economic outlook with unemployment standing at 15 percent and GDP shrank 0.7 percent in the first quarter of 2014.

Some market participants are worried the government's plans to partly reverse salary cuts in the public sector and possibly cut taxes next year could undermine efforts so far.

"The fact they don't have Troika lenders closely telling them what to do does not mean that they should delay the reform efforts achieved so far or move in a different direction," said Alessandro Giansanti, senior rates strategist at ING.

Portuguese 10-year yields rose 8 bps on Monday to hit 3.86 percent. Greek equivalents remained just shy of two-month highs, with the government's plans to scrap a legacy capital gains tax on foreign bondholders failing to soothe investors' election nerves. (Editing by Catherine Evans/Ruth Pitchford/Nigel Stephenson)

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