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UPDATE 1-Italian bond yields fall on coalition, ECB stimulus hopes

Yoruk Bahceli

* Italian bond yields fall as talks expected to conclude Wednesday

* Markets start to bet on big ECB Sept rate cut

* Euro zone periphery govt bond yields (Recasts, adds comment, rate cut expectations.)

LONDON, Sept 2 (Reuters) - Short-dated government bonds in the euro area outperformed on Monday, with Italy leading the way as political uncertainty eased and speculation grew that the European Central Bank would deliver a big interest rate cut next week.

Italy's prime minister said on Sunday he expected to settle talks over a new government by Wednesday, as the 5-Star Movement and Democratic Party (PD) are working out cabinet posts and a common agenda.

Italian bond yields fell 4 to 8 basis points, having risen on Friday after 5-Star leader Luigi di Maio said his party would only enter a coalition if the PD agreed to a string of policy demands.

The short end of the curve outperformed, with two-year yields tumbling 8 bps to -0.24%, close to its lowest levels since April 2018. Italy's 10-year bond yield fell 6 bps to around 0.98%.

The gap between short-dated Italian and German bond yields may tighten further once governmental uncertainty is out of the picture, said Peter Schaffrik, global macro strategist at RBC Capital Markets. Italian two-year bonds now trade at a 65-bps yield premium to two-year German bonds.

"It's a pretty attractive spread for a relatively moderate risk that you would take," Schaffrik said.

The next hurdle is for 5 Star's members to approve the coalition deal, agreed last week, in vote on Tuesday.

Across the euro area, short-dated bonds outperformed longer dated-peers, a move analysts attributed to ECB rate cut speculation.

The ECB meets on Sept. 12 and is widely expected to cut rates to boost economic growth and inflation. Money markets have ramped up bets on a larger rate cut than initially expected, now pricing a 60% chance of a 20-basis-point cut.

Germany's two-year bond yield was flat at -0.92% and within sight of record lows from early 2017. In contrast, 10-year bond yields were up 2.5 bps at -0.60% and the 30-year yield was up 3.5 bps at -0.18%.

The short-end outperformance follows hawkish statements last week by some ECB officials that had fuelled speculation the central bank, instead of embarking on fresh asset purchases, could deliver large rate cuts instead, said Norbert Wuthe, rates strategist at Bayerische Landesbank Wuthe.

"The decreasing likelihood of quantitative easing came with an increasing likelihood of rate cuts or even stronger rate cuts," he said.

(Reporting by Yoruk Bahceli, additional reporting by Dhara Ranasinghe; editing by Larry King)