LONDON Hints the euro zone may shift away from front-loaded fiscal austerity have been treated kindly by financial markets this week as bond investors seem comfortable with at least a measured tilt in the policy mix.
With business sentiment in many euro zone countries, notably Germany, deteriorating again this month and jobless numbers continuing to rise, policymakers have signaled a need to ease back on draconian deadlines for deep budget cuts.
Backed by the International Monetary Fund, European Commission chief Jose Manuel Barroso said popular support for the current trajectory of austerity had "reached its limits".
Barroso's economic affairs commissioner Olli Rehn stressed a longer-term approach to debt control, saying: "We have the room to make fiscal policy with a more medium-term view."
Even German finance minister Wolfgang Schaeuble acknowledged there was room for flexibility in deficit targets, although Berlin's staunch advocates of fiscal retrenchment still insisted both cuts and structural reforms must continue.
The discovery of flaws in what had become benchmark academic research used to support tight control of sovereign debt has also helped shift the debate about whether governments tackling the crisis should focus more on austerity or growth.
Far from running scared at the prospect of a loosening of austerity, as many deficit hawks have feared, major investors - encouraged by hopes of a small cut in European Central Bank interest rates next week - piled into Italian and Spanish bonds.
Italy's 10-year borrowing costs fell to their lowest since the euro crisis erupted in 2010, while two-year yields fell to their least since the euro's 1999 inception, despite its recession, massive debts and a continued political impasse.
And despite another slew of poor economic data and underwhelming results from the European corporate earnings season, euro zone stocks .FTEU3 clocked up five straight days of gains through Thursday.
Given the responses late last month to Reuters monthly fund manager survey, that should not have been too surprising. Asked whether an easing of euro zone and UK fiscal austerity would be positive for both the region's bonds and equities, 17 out of 22 global asset managers who replied said 'yes'.
TWEAKS ACCEPTABLE TO BONDHOLDERS
The euro zone policy shift, at least initially, is likely to center on pushing back on deadlines for getting annual budget deficits under 3 percent of gross domestic product.
While this appears uncontroversial for creditors, some major bond holders reckon it may be the limit of maneuverability.
David Zahn, Head of European government bonds at California-based fund manager Franklin Templeton, which has more than $800 billion in assets under management, says a "tweaking" of fiscal plans - rather than spending sprees - would be acceptable.
Zahn, who said he remained bullish on Italian government bonds while avoiding German Bunds and holding no British gilts, told Reuters this week it was important the overall fiscal program in the euro zone remained broadly intact.
"It really depends on the amount of what they do - if it's just about pushing it out a year or two but they are still basically on track, I think that's OK," he said.
"If they can come up with a pro-growth strategy that would be great - but I can't see that without lots of spending and they can't afford the spending. The market in general would not see that favorably."
Zahn said the euro was a "political animal" by construct, and that policy consensus took time to form. An investor must therefore take a long view and focus on relative value in the meantime. "It is difficult to see growth coming back to Europe in the near future but that doesn't necessarily mean you don't hold the bonds," he added.
That echoed recent comments from Scott Thiel, head of European and global bonds at the world's biggest asset manager, BlackRock - which has almost $4 trillion in assets under management. Thiel told Reuters the euro zone faced a "multi-year corrective process" and that it was way too early to look at growth today and judge long-term debt sustainability.
But some investors remain uneasy about the euro zone's debt burden and lack of economic growth and argue that the ECB's bond-buying pledge relieves governments of the need to act.
Keith Wade, chief strategist at UK-based Schroders, which manages more than 200 billion pounds in assets, said the ECB's powerful backstop for bonds and its provision of bank liquidity had positive and negative effects.
"Clearly such action has created a much-needed breathing space for the euro, but by removing the danger of crisis it has taken the pressure off governments to take action."
And many investors remain sceptical the whole euro-area debt-and-growth circle can be ultimately squared without bondholders taking a hit somewhere.
"I'm very fearful Europe won't be able to rely on austerity to solve the debt crisis," said Chris Iggo, Chief Investment Officer, Fixed Income at AXA Investment Managers, which has more than 500 billion euros of assets under management.
And "there isn't growth or inflation, so some kind of restructuring or debt relief will be necessary."
(Editing by Catherine Evans/Ruth Pitchford)