August 30, 2011 / 11:10 AM / 8 years ago

Weak demand at Italian bond auction unnerves market

LONDON (Reuters) - Italy returned to bond markets on Tuesday with a 7.74 billion euro sale that met relatively weak demand despite the ECB buying Italian debt in recent weeks, sparking a nervous reaction among investors.

Signs of lower-than-expected demand at the auction — awaited as a crucial test of emergency steps taken to stem the spread of the euro zone debt crisis — pushed Italian bond yields higher and sparked a rally in safe-haven German debt immediately after the sale.

Traders said the European Central Bank stepped in after the auction to buy significant amounts of 10-year debt, bringing yields back down.

“The results look a bit worse than the market was expecting, with the 10-year looking weak with a rather small bid cover ratio,” said Credit Agricole rate strategist Peter Chatwell.

“The market is likely to lose a bit of confidence from this auction until 10-year Italy stabilizes, which is in the ECB’s hands.”

The launch of a new 10-year benchmark bond drew bids worth 1.27 times the 3.75 billion euros sold, below the year’s average bid-cover ratio of 1.4.

The ECB began buying Italian debt on the secondary market earlier this month, bringing benchmark 10-year yields down from levels well above 6 percent, seen as unsustainable, to around 5 percent.

The new 10-year bond sold at a yield of 5.22 percent, broadly in line with grey market prices ahead of the sale. That yield compared to 5.77 percent at an auction of the previous 10-year bond in July, before the ECB’s intervention.

The auction will do little to alleviate the market’s central fear that Italy, seen as too big to be bailed out, will no longer be able to issue bonds at an affordable level to finance its huge 1.9 trillion euro debt burden.

Italy must still sell up to 90 billion euros in bonds this year and ECB purchases have been steadily decreasing.

“The ECB support was clearly crucial. Without the ECB intervention a couple of weeks ago yields would not be trading at this 5 percent level so it might have easily been a full percentage point more,” said Michael Leister, strategist at WestLB in London.

“The fact that yields remained relatively stable last Friday and more importantly this morning shows indeed that the ECB was successful in stabilizing them but the big question is what happens going further.”

The ECB has bought around 43 billion euros worth of debt since it reactivated its bond buying program earlier this month to halt the spread of the crisis to Italy and Spain. Market participants say ECB buying has focused on Italy.

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