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Why troubled euro zone bonds are outperforming Treasurys

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If you had told a bond trader three years ago that the euro zone bond market would be performing as it is now, chances are you would have been laughed out of the room.

Countries once seen as deeply troubled Spain and Ireland, now have lower yields on their 10-year bonds than the U.S, while the yield on Italian 10-year bonds is just a fraction above that of the U.S. 10-year - even though the U.S.'s economic recovery seems stronger on many metrics.

Markets have embraced European Central Bank President Mario Draghi's pledge to do "whatever it takes" to save the euro and pump money into the European banking system, and bought up peripheral euro zone bonds accordingly, driving down the yields on 10-year bonds for Italy, Spain and Ireland to record lows this week.

The ECB's most recent mass lowering of rates, and plans to issue a 400 billion euro package to target lending to small businesses, have also boosted confidence.

Ireland recently clawed its way back to an "A" rating by ratings agency Standard & Poor's for the first time since 2011, after it had to be bailed out by its euro zone counterparts and the International Monetary Fund (IMF) in November 2010.

Small wonder, then, that peripheral euro zone bond issuance is now at its highest level for the year to date since 2009, when the extent of the region's debt crisis first emerged, according to data from market analysis firm Dealogic.


Italy, currently undergoing ambitious reforms under new Prime Minister Matteo Renzi, is the biggest bond issuer among the peripheral euro zone countries so far in 2014 with $107.2 billion of bonds issued, a 56 percent increase from the same time in 2013, and nearly half of all the euro zone issuance.

Yet there, as in the rest of the periphery, the recovery still seems fragile.

"The cyclical recovery is real and robust, but the recovery in the level of output and employment in the periphery is still desperately far away from pre-crisis level," Claus Vistesen, chief euro zone economist at Pantheon Macroeconomics, pointed out.


So how have bond yields got so divorced from what's happening in the real economy?

One key reason is the search for higher returns among investors, as interest rates show no signs of rising again, brought them to the peripheral euro zone countries.

Another is that the U.S. is in the process of rowing back its quantitative easing program via a process known as tapering, while the euro zone may be just about to embark on a similar program, so looks more attractive in the short term. And the strength of the euro also attracts investors.

Still, there are concerns that the market is misjudging the ECB's capacities.

"There's too much pressure being put on the ECB to fix the euro zone's issues. The euro zone is going to get saved by global growth," Kevin Gaynor, head of macro strategy, Nomura, warned CNBC.

"It (cutting rates) smacks of desperation."


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