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Euro zone bond rally may be ending: Here’s why

The decline in the cost of repaying debt for the weaker euro zone economies in the past two years is one of the most important reasons the euro zone appears to have made a halting recovery from its debt crisis. Yet this could be coming to an end.

Look at this chart from Citi FX, which shows that foreign ownership of Spanish and Italian bonds has sunk since the beginning of 2011. Domestic banks in both countries seem to be propping up their own economies by borrowing cheaply from the European Central Bank (ECB) during its two major liquidity operations and buying up their countries' debt – which drives down the cost of repaying that debt for the country.

The question of what happens when the cheap loans are removed from this cycle has not been answered, despite ECB President Mario Draghi's pledge to do "whatever it takes" to save the euro.

(Read more: Mario Draghi's greatest hits)

At the same time, the BTP-Bund spread (the difference in Italian and German debt costs) and the Bono-Bund spread (the difference in Spanish and German debt costs) have narrowed. Both of these are viewed as a measure of the "risk premium" attached to both Italy and Spain, so their narrowing indicates that these countries are perceived as less risky.

A "sizeable portion" of the cheap loans pumped into the euro zone banking system by the ECB, known as long-term refinancing operations (LTROs), were used to buy Italian and Spanish debt due to mature at the end of 2014 or the beginning of 2015. Italian and Spanish banks were some of the biggest takers of LTROs, with close to 300 billion euros worth of the loans.

Banks across the euro zone will come under pressure to sell off riskier assets next year as a major ECB Asset Quality Review begins – which could mean that they sell off some of the bonds bought with these cheap loans. Borrowing between banks is already becoming more difficult as euro zone banks are becoming more cautious.

(Read more: Stressful times for Europe's banks)

"Italy and Spain may face mounting funding pressures in late 2014 if domestic banks are unable or unwilling to roll their maturing sovereign debt positions," Valentin Marinov, head of European G10 currency strategy at Citi, pointed out.

And other investors may sell their Italian and Spanish bonds if it looked like their economies were about to perform worse, which would send their cost higher again.

(Read more: Berlusconi gone, but Italy's problems remain)

Keeping yields low is important not only for Italy and Spain, but for the rest of the euro zone. When yields on 10-year Spanish and Italian bonds hit the danger zone of 7 percent at which other euro zone economies like Ireland and Greece had to be bailed out by international lenders, they were both seen as perilously close to needing a bailout. Spain had a bailout for its banks, after its property boom collapsed, but avoided a full Greek-style bailout.

Italy and Spain are the euro zone's third and fourth biggest economies respectively, so any threat to their stability, particularly if one of them needed a bailout, could affect the entire region – and weaken the euro.

- By CNBC's Catherine Boyle. Twitter: @cboylecnbc.

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Contact Europe: Economy

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