Are Spain and Italy headed for 1% yields?

Dhara Ranasinghe, special to

One percent: that's the level government bond yields in peripheral euro zone states could fall to amid expectations of prolonged deflation and aggressive monetary stimulus in the region, according to some analysts.

Official data published earlier this month showed that inflation in the euro zone turned negative in December, with prices 0.2 percent lower than the same month a year before. And the European Central Bank (ECB) is expected to react to this deflation risk with a government bond-buying program – also known as quantitative easing (QE) -- when it meets on Thursday.

Mario Draghi, president of the European Central Bank (ECB), gestures while speaking during a news conference at the bank's headquarters in Frankfurt, Germany, on Thursday, April 3, 2014.
Ralph Orlowski | Bloomberg | Getty Images

A bond's yield – which moves inversely to its price -- is the amount of interest paid to an investor. Low government bond yields indicate that investors have confidence in a country's ability to repay its debt, and view its sovereign bonds as a relatively safe investment.

Bob Janjuah, co-head of cross-asset allocation strategy at Nomura, said "you have to like bonds," given the worrying macro-economic environment.

Read MoreWill QE be enough to save the euro zone from deflation?

"I think deflation is a global theme and central bank success in defeating deflation has been limited – even for the Fed," he told CNBC Europe on Monday. "Fixed income is the unpopular trade out there because look at where yields are; where can they get to? I think we will see 10-year Italy and Spain yields down at 1 percent."

Benchmark 10-year bond yields are currently trading around 1.53 percent in Spain and 1.67 percent in Italy, having both fallen over 70 basis points in the past three months.

A move to 1 percent would be significant because less than three years ago benchmark yields in Spain and Italy soared above 6 percent amid fears about the euro zone's sovereign debt crisis.

"The reason that bonds yields have tightened so dramatically is not because of any fundamental change in the economies becoming any better, although some like Spain have seen great improvement and have carried out reforms," said Bill Blain, a strategist at Mint Partners in London.

"The reason comes from (ECB President Mario) Draghi's promise to 'do whatever it takes' to save the euro and all the discussion about QE on Thursday," he said. "And the expectation is that if QE happens, there will be a further burst of bond buying causing yields to tighten to 1 percent in Spain and Italy. Personally I doubt that's going to happen."

Blain said that if the market perceives an ECB bond-buying program as too little, too late, yields in the euro area were unlikely to fall much further.

Read MoreWarning! Volatility may await if ECB launches QE

Italy, Spain 10-year bond yield to fall to 1%: Janjuah

Indeed, analysts said that Thursday's ECB decision could prove to be a key turning point for the region's debt markets.

"This is likely to be the moment of truth for yields in the euro area," said Nicholas Spiro, managing director at Spiro Sovereign Strategy in London. He also stressed that the region's peripheral debt markets may not be immune from political developments in Greece.

Greek voters go to the polls this weekend to elect a new government, with the anti-bailout Syriza party doing well in the polls. A potential win by the radical leftist party has unnerved markets, amid jitters it could lead to a clash between Athens and its international lenders – the European Union and International Monetary Fund.

Read MoreWould forgiving Greece's debt really be that bad?

While euro zone peripheral bond yields often move in tandem, benchmark 10-year yields in Greece have diverged from Italy's and Spain's over recent months, rising sharply to above 9 percent.

"It is conceivable that yields in Spain and Italy could fall further, but that all depends on the extent that post-election Greece affects sentiment towards the other peripheral markets," said Spiro.

Follow us on Twitter: @CNBCWorld