LONDON Yields on Italian and Spanish bonds fell sharply on Monday after the European Central Bank bought the debt in an attempt to brake the spread of the euro zone crisis.
That effectively ring-fenced the two markets from a further sharp sell-off in other risky assets as investors, rattled by Standard and Poor's stripping the United States of its prized triple-A credit rating, focused on the dwindling prospects for global growth.
Safe-haven German Bunds pared earlier losses and benchmark U.S. Treasury yields fell as equities slid.
Traders said the ECB was mostly buying five-year Italian and Spanish bonds -- although it also bought maturities went up to 10-years -- alongside other peripheral paper, after it said on Sunday it would "actively implement" its bond-buying program.
"We've had a number of different commitments from policymakers over the weekend and taking them together we at least have a productive stop-gap measure, if it can continue," said Nomura rate strategist Sean Maloney.
Italian and Spanish bond yields were up to 95 basis points lower, with 10-year Italian yields down 70 basis points at 5.39 percent and equivalent Spanish yields down almost 80 basis points at 5.30 percent.
Traders estimated the ECB had bought up to 2 billion euros of paper in lots of 20-25 million euros through a large number of dealers.
Italian and Spanish yields have soared in recent weeks, threatening to lock both countries out of financing markets and marking a major escalation in the 18-month-old debt crisis. With funding costs rising to levels widely deemed unsustainable, the ECB, which had so far bought bonds only of bailed-out Greece, Ireland and Portugal, was seen as the last line of defense.
Italy pledged last week to speed up austerity measures and social reforms in return for the ECB's help with funding, something analysts said was key to a longer-term improvement in sentiment.
"The trick is (for the ECB) to buy enough to show such a commitment to a certain yield level that investors feel comfortable in buying alongside the ECB," said Gary Jenkins, head of fixed income at Evolution Securities.
"That's a tough trick to pull off because if the market is not confident of ultimate full repayment then it will eventually just allow the authorities to fund and bail out as in the cases of Greece etc."
September German Bund futures were 30 ticks lower than at Friday's settlement close at 132.06, although off session lows of 130.57. Italian BTP futures were almost 5.5 points higher.
Ten-year Bund yields were 2.5 basis points higher at 2.39 percent, well off session highs, as European equities slid into negative territory, down nearly 2 percent on the day.
"It's a massive asset allocation out of stocks and into Bunds," a trader said.
"Italy and Spain are ring-fenced for now by the ECB but outside of that the focus is on the global situation and are we looking at interest rate cuts and global liquidity injections?"
GROWTH WORRIES, U.S. DOWNGRADE UNDERPIN MARKETS
Ten-year Bund yields were around 15 basis points lower than at the beginning of August despite policymakers' efforts to rein in the euro zone debt crisis.
The risk-off tone came despite Group of Seven leaders pledging they were "ready to take action to ensure stability and liquidity in financial markets" as fears U.S. spending cuts would slow global growth spooked investors.
U.S. Treasury yields, benefiting from safe-haven flows out of riskier assets despite the downgrade, were up to 8 basis points lower near Friday's 10-month lows.
"The muddling through approach of policymakers on both sides of the Atlantic carries much of the blame for the current crises...policymakers alone hold the keys to determining whether this latest development triggers a new recession or not," Societe Generale economists said in a note.
As 10-year Treasuries outperformed Bunds in early trade, the spread between the two yields briefly reached zero. But as Bunds pared losses the spread widened again, with Treasuries yielding around 11 basis points more than Bunds.
(Reporting by Kirsten Donovan, graphic by Scott Barber)