Politics to offer fleeting Italian bond respite

LONDON (Reuters) - The formation of a national unity government in Italy will drive its borrowing costs back down from painful levels but any respite will be short-lived without aggressive support from the European Central Bank.

Italian bond yields have eased from euro-era peaks because an emergency government is expected to replace Prime Minister Silvio Berlusconi's centre-right coalition. The ECB's purchases of Italian debt in the secondary market so far have also helped.

If the new Italian unity government is confirmed, 10-year bond yields could fall by up to half a percentage point, according to analysts.

But the hurdles that will face the new government mean analysts expect the cost of borrowing to rise swiftly back above 7 percent, the threshold after which Italy is expected to begin to struggle to finance its 2.2 trillion euros (1.86 trillion pounds) of debt.

"There could be a substantial move lower in yields but they are bound to be given back very quickly," said Lyn Graham-Taylor, a strategist at Rabobank in London.

"Even if there is a government of national unity there is still huge implementation risks in any austerity measures. Even after two or three days, this change will be insufficient as a circuit breaker" for the Italian bond market.

LAST RESORT

Investors know any new government will face huge opposition from parties on both sides of the Italian political spectrum and that austerity measures are likely to be unpopular with voters.

Some financial firms are therefore giving a wide berth to debt issued by Italy and other Southern European states.

"We see no reason yet to change our peripheral underweights from late August and are still looking for new (German) Bund yield lows before year-end," Commerzbank strategists said.

The ECB is therefore increasingly viewed by traders as a more effective source of sustained support for Italian bonds.

"To have bond yields held down by the ECB spending, say, 1 trillion euros on bonds of various sovereigns, would be a really helpful way to proceed through this hugely difficult period that Europe is confronting," James Shugg, an economist at Westpac told Reuters Insider Television.

The ECB has already bought a total of 183 billion euros worth of Southern European sovereign debt since its forays into the secondary bond market began in May 2010.

But the central bank is loath to be the lender of last resort and wants Italy to implement fiscal reforms it had promised to undertake. That leaves Italian bond markets acutely vulnerable to political and other risks.

IMMINENT TESTS

The most immediate risk to any relief rally inspired by Italian political developments is a bond auction on Monday which will offer up to 3 billion euros of five-year government debt to investors.

Italy was this week forced to pay an interest rate of 6.087 percent for one year debt, the highest in more than a decade.

"It (the formation of an new government) will be a very good step but I can't be 100 percent confident that we can get a 100, 200 basis point collapse in Italian yields," said David Keeble, a strategist at Credit Agricole in New York.

The credit market also highlighted investors' growing uncertainty about Italy's ability to repay debt in the coming years -- the cost of insuring one- or two-year Italian debt is stubbornly above the insurance premium for five-year debt.

Typically, five-year credit default swaps (CDS) trade above shorter-dated ones.

"Even if a new, credible government is installed it will still face the problem of anaemic growth that prevents Italy from making inroads into its debt burden," said Gavan Nolan, analyst at Markit, which provides CDS data.

"An effective backstop of Italy and Spain is still needed."

(Graphics by Scott Barber, editing by Swaha Pattanaik and Ruth Pitchford)