Investors Bet on Draghi Over Politics as Bonds Gain: Euro Credit

Investors are pinning their hopes on European Central Bank President Mario Draghi again helping overcome political bungling.

With Italy beginning a ninth week without a government following inconclusive elections, traders betting the ECB is set to cut interest rates to confront a second year of recession sent euro-area debt surging as Italian two-year bond yields fell to a record low.

“Central bank activity is a rising tide that carries all boats,” said Russel Matthews, a money manager at BlueBay Asset Management in London, which oversees $47 billion and owns more Italian and Spanish debt than his benchmarks. “The ECB has to respond given the ever deteriorating economic environment.”

Italian 10-year bond yields closed below 4 percent yesterday for the first time since November 2010 and slipped 4 basis points today to 3.91 percent at 9:10 a.m. in Rome, while the two-year yield fell to 1.15 percent. The ECB may cut borrowing costs if data show a need for it Executive Board Member Joerg Asmussen said April 20 on a panel in Washington.

Fourth Cut

Futures contracts based on the euro interbank offered rate, a benchmark of how much banks charge to lend to one another, signal increasing expectations for the ECB to lower its main refinancing rate from the record-low 0.75 percent it has maintained since July. The implied yield on the contract for June is at 18 basis points, the lowest since Jan. 2 and down from the high for this year of 42 basis points on Jan. 25.

A reduction in the ECB’s record-low benchmark rate of 0.75 percent would be the fourth since Draghi took office in November

2011. His biggest impact has been policy moves that flooded the banking system with more than 1 trillion euros in cheap loans and a 2012 pledge to buy bonds of debt-laden nations agreeing to sign up to economic reforms.

The rate-cut speculation extended gains in Italy, where markets have climbed even as political wrangling forced the unprecedented re-election of 87-year-old Giorgio Napolitano as head of state and left caretaker Prime Minister Mario Monti in place since the Feb. 24 and Feb. 25 vote.

‘Nothing Happened’

“Belgium was without a government for a year and nothing happened, so investors know things can get done anyway,” said Angelo Drusiani who manages about 3 billion euros at Banca Albertini Syz & C. in Milan. “Italy has undertaken a lot of reforms and spreads will keep falling as long as the next government continues with fiscal discipline and reform.”

While parliament was paralyzed by haggling among three blocs, the spread between Italian and German 10-year bonds has narrowed to 266 basis points from 287 basis points before the election. Drusiani predicts the difference will close to about 150 basis points.

The reappointment of Napolitano, who had the support of both the Democratic Party and former Prime Minister Silvio Berlusconi’s People of Liberty party, may have set the stage for a possible coalition. A deal, which may come as soon as today, would give Italy the majority needed to pass economic stimulus measures and respond to the country’s longest recession in more than 20 years.

Recession, Debt

The economy has contracted for eight straight quarters and the government forecasts a 1.3 percent decline this year. Unemployment is near a 20-year high of almost 12 percent, and debt is set to reach a record 130 percent of gross domestic product, second in the euro region only to Greece.

Still, Monti’s austerity policies have kept the deficit in check, delivering a primary surplus that helps reduce debt.

“Fiscal policy is unlikely to change course, but the scope for deeper economic policy changes remains challenging,” Goldman Sachs Group Inc. analysts Francesco Garzarelli and Silvia Ardagna wrote in an April 21 note. They see the 10-year bond spread at 275 basis points. “Lower spreads await concrete evidence of stabilization in economic activity, and a resumption of economic reform initiative.”

Should Italy’s political parties be unable to form a government, the president would be forced to call snap general elections, a scenario that would increase uncertainty.

“Italy remains in a dangerous deadlock with few politically strong and respected men behind Napolitano,” Citigroup Inc. analysts Mauro Baragiola, Tina Fordham, Azzurra Guelfi and Antonella Bianchessi wrote in a note on April 22 expressing concern over the fragmentation of political parties. “Under these circumstances it may be positive that Italy stays on autopilot a bit longer, albeit under the leadership of a near-nonagenarian.”

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