May 3, 2018 / 7:33 AM / in 20 days

Southern Europe bond spreads defy the odds even as ECB pullback looms

LONDON (Reuters) - At a time when the impending withdrawal of European Central Bank stimulus was expected to hurt southern European bond markets, so-called “peripheral” euro zone debt continues to outperform its higher-rated peers.

Italian, Spanish and Portuguese bonds have been among the bloc’s best performers over the past year, and yield premia — or spreads — over benchmark German debt have narrowed relentlessly.

Their outperformance has even defied data indicating Europe’s growth acceleration may be running out of steam.

And despite recent volatility in the wake of Italy’s inconclusive March 4 election, spreads remain near their tightest levels in months, or even years.

(Graphic: Strengthening economy underpins Italian spread - reut.rs/2KlBZQj)

“There has been a regime change in sovereign spreads, which are now reacting mostly to economic developments. As long as growth remains healthy, we can see spreads tighten further,” said Mizuho strategist Antoine Bouvet.

Reasons for the “regime change”?

First, the three Southern European countries are well and truly out of recession, helped by 2.55 trillion euros in ECB stimulus. The euro bloc posted its fastest economic growth in a decade last year at 2.7 percent.

Even if growth slows from there, it is a far cry way from 2010-2012, when Spain and Portugal required bailouts and Italy’s debt levels spiraled to record highs.

Second, unlike a year ago, anti-establishment parties such as Italy’s 5-Star Movement are not considered an existential threat to the single currency. Italy may not have a government yet, but the Italy/Germany 10-year bond yield spread is near the tightest since August 2016 at 110 bps.

So can it continue?

The Italy/Germany spread can go all the way to 90 basis points, Nick Gartside, chief investment officer at JP Morgan Asset Management, told Reuters in January when the spread was 145 bps.

That target now seems within reach, especially as U.S. Treasuries look expensive, once currency hedging costs are taken into account. That means many European investors who would have bought nominally higher-yielding Treasuries, may seek domestic alternatives.

“Ten-year Italian government bonds at nearly 1.8 percent, or even (German government bonds) at 0.6 percent, yield more than the near-zero yield on equivalent currency-hedged U.S. Treasury bonds,” said Andrew Bosomworth, head of portfolio management, Germany, for PIMCO, the world’s largest bond manager.

In addition, Italy’s “real” yield, a measure looked at by some investors that discounts the effect of inflation, is higher than that of the United States.

(Graphic: Cost of FX hedging cuts U.S. yield advantage for Europeans - reut.rs/2JGE0Fv)

(Graphic: Italy "real" yield higher than that of the U.S. - reut.rs/2rcVC5c)

PERIPHERY TO SEMI-CORE

Rabobank strategist Richard McGuire predicts Italy/Germany will reach 100 bps but reckons Spain will outperform.

Spanish spreads stand around 72 basis points, having tightened from around 150 bps a year ago ES10YT=RR.

“The Spanish spread (over Germany) has traditionally found resistance at the 100 basis-point mark ever since the crisis,” McGuire said. “But right now it is well below that level and we think it could go as low as 50 basis points.”

Spain may represent the best “regime change” example, in fact. With sovereign credit ratings back in “A” territory, many see Spain following Ireland’s example to transition out of the periphery into “semi-core” - market jargon for the debt of Belgium, France and Ireland.

Portuguese spreads meanwhile recently touched 109 bps, their tightest since 2010. It caps a remarkable comeback for a country until recently classed as junk by the big ratings agencies.

S&P Global and Fitch late last year raised their Portuguese ratings back to investment grade, helping push its 10-year borrowing costs below Italy’s.

In early 2017, they were 200 basis points higher.

For this reason, the Portugal/Germany spread is the one which may not have legs — investors do not see it sustainably trading tighter than Italy, a larger economy with a far more liquid bond market.

PERIPHERAL DANGER

The periphery trade however faces the same danger as it always did - the end of ECB bond-buying. ING analysts for instance predict Italian and Spanish spreads will widen to 150 bps and 80 bps respectively by the end of 2018.

Some investors such as Eric Brard, head of fixed income at Amundi, may also switch back to higher-rated French and German debt should yields there rise. German 10-year yields hitting 1 percent would be the time to return to the euro zone “core”, Brard said.

    “That would also mean the French (government bond) market would be above 1.20 percent on the 10-year, we would rather be in these better-rated names,” he added.

In February, when German 10-year yields rose above 0.80 percent, that day looked ominously close.

But with euro zone growth seemingly cooling — the economy grew just 0.4 percent in the first quarter — and the ECB sounding cautious on monetary policy, German yields are back at 0.6 percent. This suggests the gravy train will chug along for southern Europe in the foreseeable future.

(Graphic: Portugal goes from outlier to outperformer - reut.rs/2JGPEQN)

Reporting by Abhinav Ramnarayan and Fanny Potkin; Graphics by Abhinav Ramnarayan and Saikat Chatterjee; Editing by Sujata Rao and Hugh Lawson

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