Italian and Spanish yields fall in anticipation of ECB

Italian and Spanish yields fell on Tuesday in anticipation of fresh support from European Central Bank buying while Bund futures traded in a wide range, driven by extreme volatility in equity markets.

Traders said the ECB had not yet entered markets to support Italian and Spanish debt in this session but as long as confidence remained high that it would, investors were prepared to continue buying to close out bets of further rises in yields.

"We haven't seen (ECB buying) yet but the expectation is that they will be in again, and in good size," a trader said.

The central bank became a reluctant buyer of Italian and Spanish debt for the first time on Monday in an emergency response to head off mounting pressure on the highly indebted sovereigns.

That support has seen yields fall by over one full percentage point on 10-year Italian and Spanish debt. The Italian yield was down 19.7 basis points on the day at 5.134 percent while Spanish debt stood at 5.05 percent, down 16.3 bps.

Despite the gains, analysts said it was important that the ECB continued to display its commitment to Spain and Italy to avoid a renewed investor selloff that would propel the countries' yields back to unsustainable levels.

"It still remains to be seen how credible the ECB is this time round and how sustained they are in terms of their purchases, and we wouldn't exclude for the whole thing to turn around again," said WestLB rate strategist Michael Leister.

Across asset classes, worries that the global economy could slip into recession dominated, causing stock markets to fall and pushing safe haven assets such as gold to all-time highs.

European equities fell, but losses were less severe than markets had originally anticipated after major Asian indices pared their losses following a severe overnight selloff.

Bund futures were last flat at 133.08 having earlier sunk to a session low of 132.46. The contract had already traded in a wide range of more than 100 ticks during a volatile session.

"Given the high levels we have been trading at and the extreme volatility, moves don't have to be based on a sustained change in sentiment. It's more about short-term mood swings," WestLB's Leister said.

The bond market's fragile risk appetite looked set to keep the pressure on the euro zone's lower-rated debt, testing the resolve of the ECB to support Italy and Spain and ramping up pressure on the region's other sovereigns.

"At the end of the day Italy and Spain are out of the game so we'll be looking at Belgium and France next -- the ones without protection," a second trader said.

French government bonds were the worst performer in the currency bloc with 10-year yields 7.5 bps higher on the day at 3.22 percent.

S&P does not expect to downgrade its AAA rating on France within the next two years, the head of the credit agency's European sovereign ratings unit told a German newspaper on Tuesday.

Eyes on FED

Investors were also looking ahead to the U.S. Federal Reserve's policy meeting later in the day for signs the central bank might announce further measures to shore up financial systems and invigorate growth.

"They can't just ignore equity moves like this, they will try and be as upbeat on growth as they can... but I don't think you're really going to see much beyond the 'lower-for-longer' (rates) emphasis," said Lloyds Bank strategist Charles Diebel.

Analysts said that while hopes of a third round of U.S. financial stimulus looked set to be disappointed, expectations centered on other less radical options such as extending maturities of the bank's portfolio.

With risk appetite continuing to drive bond markets globally, anything that provided a boost to investor sentiment was also likely to hurt appetite for Bunds, although falls would be limited by the region's own debt crisis.

[Source: By William James, Reuters, London, 09Aug11]

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