July 3, 2018 / 8:08 AM / 4 months ago

Italy/Germany bond yield gap narrows as Merkel hangs on

* Italy/German spread at tightest in a week at 231 bps

* Threat of German government collapse recedes

* Safe haven German bond yields higher 2 bps

* Trade war threat still hangs over market

* French 30-year yield hits 18 month low

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr

By Abhinav Ramnarayan

LONDON, July 3 (Reuters) - German borrowing costs rose and Italian spreads tightened as concerns over a possible collapse of the German government subsided, but the moves were muted as the threat of a full-blown trade war hung over the market.

German conservatives settled a row over migration late on Monday that had threatened to topple Chancellor Angela Merkel’s coalition after talks with her interior minister led him to drop a threat to resign.

The news encouraged investors to shed safe haven German Bunds and instead buy Italian government debt, reducing the closely-watched spread between the 10-year bond yields of the two countries by 4 basis points to its narrowest in over a week.

“If politics is going to be less of a threat during the summer holiday season, you can make the case for being invested in peripheral markets because of the higher returns,” said DZ Bank analyst Andy Cossor.

Even after Tuesday’s tightening, Italy’s 10-year government bond is yielding 231 bps more than its German counterpart.

But Cossor warned that other risks remain, particularly when Italy’s new anti-establishment government, which has high spending plans, begins discussions with the European Union over next year’s budget.

In addition, the possibility of a full trade conflict between the United States and Germany is keeping major government bond yields pinned near recent lows.

President Donald Trump made a veiled threat to the World Trade Organization on Monday hours after the EU threatened retaliation to U.S. tariffs on European cars and car parts.

Even though the 10-year German yield rose 2 bps to 0.32 percent on Tuesday, it is still not far from a five-week low of 0.284 percent on Monday and around half May’s high of 0.65 percent.

Other major euro zone bond yields were flat to a touch higher although Italy was the outlier, with two-, five- and 10-year yields down 2-3 bps.

LONG-DATED BID

Long-dated euro zone government bonds have been in demand after a Reuters report that the ECB is considering buying more longer-term debt from next year.

On Tuesday, French 30-year bond yields dropped to an 18-month low of 1.50 percent. Other long-dated bond yields were higher on the day but also not far from recent lows.

“The value in the very long-end of the French curve, relative to Germany, is only just beginning to be realised by investors,” Mizuho’s head of rates strategy Peter Chatwell said in a note.

Elsewhere, investors gave the cold shoulder to $125 billion of U.S. Treasury bills for sale on Monday with bidding for some issues at its lowest in nearly a decade.

Reporting by Abhinav Ramnarayan; editing by David Stamp

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