September 4, 2019 / 7:09 AM / 3 months ago

REFILE-UPDATE 4-Ebbing political risk lift German yields; Italy rally continues

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* German Bund yield set for biggest 1-day jump since mid-July

* Italian 10-year bond yield falls to record low

* Market QE expectations ease

By Yoruk Bahceli and Dhara Ranasinghe

LONDON, Sept 4 (Reuters) - German bond yields jumped on Wednesday to their highest level in almost two weeks as the approval of a coalition government in Italy and the UK parliament’s battle to avert a no-deal Brexit eased some of the political risks weighing on the market.

Bond yields rose around 5-6 basis points across the euro zone, with the exception of Italy, as comments from European Central Bank (ECB) policymakers appeared to dampen expectations for aggressive ECB stimulus next week.

Italian bonds continued their rally after the 5-Star Movement approved a coalition with the centre-left Democratic Party on Tuesday, removing a final hurdle to the formation of a new government .

Ten-year Italian yields have fallen six days out of the last seven, touching a new record low of 0.803%. They were above 1.5% at the start of August.

Also crucially, Brexit uncertainty ebbed slightly, after an alliance of opposition lawmakers defeated the government on Tuesday, allowing them to try to pass a law which would force an extension to Britain’s exit date and avoid a no-deal Brexit on Oct. 31.

The prospect of Britain crashing out of the EU without agreeing transition arrangements is viewed as hugely damaging to the UK as well as to euro zone economies.

“It looks like the easing of the Brexit concerns to a degree and the recovery in risk sentiment is behind the bond selloff,” said Commerzbank rate strategist Rainer Guntermann.

Meanwhile, Bank of France governor Francois Villeroy de Galhau was quoted as saying on Tuesday that relaunching the ECB’s bond purchasing programme was open to debate at the current juncture.

A Reuters story also quoted several sources as saying ECB policymakers were leaning towards a stimulus package that includes a rate cut, a beefed-up pledge to keep rates low for longer plus compensation for banks over the side-effects of negative rates. Resuming asset purchases remains uncertain, they said.

“This raises the risk that there is disappointment at the upcoming meeting, relative to what markets are expecting,” said Benjamin Schroeder, senior rates strategist at ING.

Germany’s 10-year Bund yield - the euro zone’s key safe haven asset - was set for its biggest one-day jump since July this year, up 3.5 bps to -0.68%. It hit a high of -0.635%.

Commerzbank’s Guntermann said comments from incoming ECB chief Christine Lagarde, in which she said that highly accommodative monetary policy for a prolonged period remains necessary, were in line with recent remarks and therefore provided an excuse for investors to sell bonds.

ITALY SHINES AGAIN

As Italian borrowing costs fell further, the closely-watched 10-year bond yield gap over German yields tightened as much as 145 bps — the narrowest in more than a year.

Italy also outperformed peripheral peers Spain and Portugal whose 10-year yields rose around 5 bps on the day, a sign that some investors could be switching portfolios away into higher-yielding Italy.

Spanish 10-year debt yields are around 0.169% while Portugal pays 0.17%.

“The only place where you can see yield is Italy, so (there is yield) compression going on with the Bund,” said Pooja Kumra, European rates strategist at TD Securities. “You (also have more of a yield pick-up compared to other periphery (countries).”

Reporting by Dhara Ranasinghe and Yoruk Bahceli; Editing by Gareth Jones and Alexandra Hudson

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