The European bond market's problem children have emerged from the naughty corner.
France and Italy were the subject of much fixed-income hand-wringing at the start of the year. These jumbo issuers both faced the prospect of elections that threatened to upend political stability, but these risks have (somewhat) passed. The recent out-performance of both nations' bonds has been impressive. The question is where they go from here.
Newly-elected French President Emmanuel Macron can seemingly do no wrong and France is back as the bastion of the European dream. This has forced under-weight investors to throw in the towel and recapture their love for Gallic debt.
The yield on the 7 billion-euro ($7.9 billion) 31 year bond France issued mid-May has shrunk about 35 basis points. And Le Spread -- the gap of French yields over Germany -- is now back to pre-Trump levels. Ten-year spreads have settled in the middle of the 15-50 basis point range that characterized the last two years. Anyone in the market for substantial outperformance had best look elsewhere.
Step forward, Italy. Earlier this month, a multi-party agreement on a new election law unraveled. This undermined the prospects for a vote in the autumn that could have produced unsettling results, including a win by the anti-establishment Five Star Movement.
The yield on Italy's new 6.5 billion-euro 31-year bond rejoiced, coming in around 35 basis points. The timing of the issue turned out to be fortuitous for investors, coming days before the election law died.
Compared to European peripheral debt, Italy has rather a disappointment, and missed out on some of the post-Macron euphoria. Yet with Italy there is much further room to recover.
The 10-year spread to Germany is still 70 basis points higher than the norm of around 90 to 135 basis points seen throughout most of 2015 and 2016 -- to be sure this period has not been without yield spikes not too far from current levels. But the median of about 125 basis points is still some way to go.
An imminent return all the way down to those levels might be too optimistic. The Italian elections will have to take place before May 2018. And the nation's banking sector is a long way from stability.
But investors hungry for yield in a return-starved summer may well find the extra pick-up tempting especially now that the French rally is running out of gas.
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