Peripheral Bond Rally Is Threatened as Political Concerns Emerge

  • Investors to focus on politics if ECB disappoints: ABN Amro
  • ‘Scope for rally rather limited’: Credit Agricole’s Kumar

Spanish and Italian government bonds, which have rallied despite looming political risks, may see recent gains relative to benchmark German securities tempered by year-end, according to ABN Amro Bank NV.

Europe’s higher-yielding sovereign debt benefited amid speculation that the European Central Bank will step up stimulus in the wake of the Brexit vote, as well as broaden rules of its asset-purchase program to address a scarcity of eligible securities. Any disappointment with the central bank’s decision will lead Spain and Italy’s bonds to underperform as investors will shift their focus to the political backdrop, according to Kim Liu, a senior rates strategist at ABN Amro in Amsterdam.

“There are still some question marks” around economic fundamentals in countries such as Italy and Portugal, while the political situation is not yet resolved in Spain, Liu said. “When you sum up all these factors, we think the rally is not justified. With the expensive levels we have now, these bonds are vulnerable.”

Spanish 10-year bond yields rose six basis points, or 0.06 percentage point, to 1.01 percent as of 4:11 p.m. London time. The 1.95 percent security due in April 2026 fell 0.55, or 5.50 euros per 1,000-euro ($1,114) face amount, to 108.635. The yield fell to a record-low 0.91 percent on Aug. 18.

Yield Gap

Benchmark German 10-year bund yields increased two basis points to minus 0.07 percent, leaving the yield difference, or spread, between the securities at 1.08 percentage points. The gap widened to 1.94 percentage points on June 24, the day the results of Britain’s decision to leave the European Union became clear. It narrowed to less than 1 percentage point on Aug. 18 for the first time since December.

The extra yield investors demand to hold Italy’s 10-year bonds instead of German debt was 1.21 percentage points, close to the lowest since April and down from a one-year high reached on June 24, the day after the U.K. voted to quit the world’s biggest trading bloc.

ABN’s Liu forecasts Spain’s 10-year bond yield spread over German securities will expand to 1.20 percentage points by year-end, and Italy’s to widen to 1.50 percentage points.

ECB officials, led by President Mario Draghi, are scheduled to announce their latest policy decision on Sept. 8.

Political Challenges

While bonds of lower-rated nations in the euro region were left unscathed by the Brexit vote, political risks loom. Spain is struggling to form a government even after two general elections in almost nine months, while Italy faces a banking crisis and a constitutional referendum that may prove crucial to the future of its Prime Minister Matteo Renzi.

Spain’s Acting Premier Mariano Rajoy faces a confidence vote in Parliament later Wednesday, which he is widely expected to lose even after signing a pact with centrist party Ciudadanos to form a government. 

“The scope for rally is rather limited from here,” said Mohit Kumar, head of rates strategy at Credit Agricole SA’s corporate and investment-banking unit in London. “We will get a bit of a near-term selloff, in Italy in particular” given the referendum and concerns over the banking sector, he said.

Kumar sees Italy’s yield spread over German at 1.25 percentage points by year-end, and Spain’s at 1.05.

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