Europe's risky bonds tempt traders as ECB signals no taper yet

Brussels

A BATTLE is raging in Europe's riskiest government-bond markets between fear that central bank support is waning and desire to snap up some of the region's most lucrative assets.

Nowhere is the tension more evident than in Italy's sovereign debt, where the longest run of weekly declines for the country's 10-year notes since 2018 was followed last Friday by the most explosive two-day rally since mid-March.

Spurring the moves is a debate over whether the European Central Bank is going to slow its asset purchases next month as the economy bounces back from the steepest recession in decades. For those willing to bet against it, the latest rise in yields was too good to pass up.

"Volatility will increase now that there are more competing drivers and increasing questions about the ECB's willingness to buy bonds aggressively," said Jan von Gerich, chief strategist at Nordea Markets.

President Christine Lagarde appeared to push back against some of the speculation percolating in the market, playing down the possibility of a major change away from the current stimulus settings when policy makers meet in June.

Her comments knocked the euro, which fell as much as 0.5 per cent against the US dollar last Friday, retreating from a near five-month high. And it bolstered the case for loading up on Italian debt, which after a sell-off this year boasts a yield of over one per cent, one of highest in the eurozone.

"The risk of a premature tightening is lower than in the past, and is currently over-estimated by market participants," Peter Chatwell, Mizuho International's head of multi-asset strategy, wrote in a note to clients.

He expects that the extra spread on 10-year Italian over equivalent German securities will narrow to 80 basis points from around 117 currently. Whether that happens or not rests to a large extent on the inflation outlook.

If the latest bounce in consumer prices is more than just a transitory shock as economies reopen after the pandemic, then the case for more monetary support could unravel, denting demand for riskier peripheral debt in particular.

Five-year inflation swaps, a gauge of expectations for rising prices over the next decade, show investors pricing in a rate of around 1.6 per cent, close to the highest level since 2018.

For bond bulls though, that may be the peak. Mizuho and Rabobank International are among banks saying that June is too soon for the ECB to start slowing purchases under the pandemic programme, citing a regional economic recovery that is only just getting underway.

Meanwhile, NatWest Markets argues that the ECB will still be supportive enough to help insulate the country from any extended sell-off, while faster economic growth will also support the market.

"The key thing for Italy is that the ECB - and central banks in general - is that they will be the last to believe and react to the inflation story," said Imogen Bachra, a European rates strategist at NatWest.

"The recovery story should be a bigger positive for Italy than the withdrawal of ECB support." BLOOMBERG