March 22, 2013 / 1:15 PM / in 5 years

EURO GOVT-Spain, Italy debt up as Cyprus seeks crisis solution

* ECB safety net seen keeping Cyprus contagion in check
    * Cyprus scrambles to avert funding crisis
    * German Bunds underpinned as EU deadline for Cyprus nears

    By Emelia Sithole-Matarise
    LONDON, March 22 (Reuters) - Spanish and Italian bonds
rallied on Friday after Cyprus said it had reached a deal to
spin off the Greek units of its debt-ridden banks as part of
efforts to contain its funding crisis.
    The Mediterranean island said the Greek deal was favourable
to Cyprus, which is facing a Monday deadline to raise the 5.8
billion euros needed to secure a 10 billion euro international
lifeline or face the collapse of its financial system.
    Spanish 10-year bond yields were last 16 basis
points down on the day at 4.835 percent, outperforming
equivalent Italian ones which were 12 bps lower at 4.52 percent
    "We still think that the base case is that they'll find a
solution in the end and find this 5.8 billion that's missing for
the bailout. We still see a lower probability of a worst case
outcome," said Alessandro Giansanti, a rate strategist at ING.
    Spanish and Italian yields have reversed this week's rise
triggered after a European Union proposal - rejected by Cypriot
lawmakers - to impose a levy on bank deposits to raise funds
needed to secure an international bailout.
    Demand for bonds issued by the euro zone's troubled third
and fourth largest economies has been resilient in the face of
Cyprus's debt problems on investor conviction that the European
Central Bank will step in with bond-buying support.
    "The market has absorbed quite a bit of bad news recently
and it takes increasingly even worse news to shake up some of
these peripheral spreads," said Citi strategist Peter Goves.
    "You've still got the ECB saying it will be providing
liquidity needed and the OMT (ECB bond-buying plan) is still
there waiting in the wings and you've got authorities stressing
this is a special case. That probably goes some way to explain
some of the market dynamics."
    Although many in the market expect a last-minute solution 
to stop Cyprus from becoming the first euro zone state to quit
the currency bloc, the uncertainty is feeding demand for
safe-haven German debt going into the weekend, pinning 10-year
yields near 2013 lows of 1.34 percent.
    Talks in Moscow on a funding lifeline from Russia also ended
without result. 
    German 10-year yields were last 1.5 basis
points down at 1.36 percent while the 30-year bond yield
 was 3 bps lower at 2.23 percent, around its lowest
since late December.
    "They (EU) are pushing for a solution to come over the
weekend but we still have the risk that the situation can get
out of control especially in terms of the banking sector. That's
why we have pressure for lower core yields," said Giansanti. 
    Bund futures were last 3 ticks up on the day at
144.49, retreating from a session high of 144.83 after news of
the Cypriot-Greek bank deal. 
    Trade in Bunds, perceived as a safe haven at times of market
stress, was expected to remain volatile given doubts over Cyprus
and Italy's struggle to form a government almost a month after
its inconclusive elections.
    "Every headline moves the market at the moment so it's quite
hard to trade. Going into the weekend people aren't going to go
much short (on Bunds)," one trader said. 
    "We're remaining constructive on Bunds. We still think 1.25
(percent in 10-year German yield) is a viable target for the
market. The market is fairly well underpinned at the moment."
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