* Markets anticipating policy change at the ECB
* Euro zone's "weakest links" seen most vulnerable
* Two years of QE on peripheral spreads: reut.rs/2njDkO9
* Euro zone bond returns: reut.rs/2mYpNZU
By John Geddie and Dhara Ranasinghe
LONDON, March 24 Big bond funds are becoming
increasingly reluctant to lend to the euro zone's weakest
members, looking past a crowded electoral calendar to an
eventual winding down of the European Central Bank's ultra-loose
In recent months, the funds have been hiking the premiums
they demand to buy bonds from highly-indebted southern European
states such as Portugal and Italy.
Many analysts have put much of that to fears that the
anti-establishment wave behind Brexit and Donald Trump's U.S.
presidential election win could sweep anti-establishment parties
to power in a series of European elections this year.
But the first of those votes in the Netherlands last week
threw into sharp relief that for many investors there are more
risks facing the bloc's weakest debt markets than just politics.
There was little change in relative borrowing costs after
Prime Minister Mark Rutte fended off a challenge from the
far-right populist Geert Wilders in the Dutch election.
Top of the risks list is whether the European Central Bank
will soon withdraw the life support that has kept many of the
weaker economies functioning and compressed government bond
"The better the political outcome in all of these European
elections, the more flexibility the ECB has to one day withdraw
the stimulus," said Michael Krautzberger, the head of European
fixed income at the world's biggest asset manager, BlackRock.
"I would expect that we have much more country
differentiation in a scenario where the ECB finally withdraws
from the market because that uniform factor falls away."
At the start of April, the ECB will scale back the billions
of euros its spends each month on a bond-buying scheme designed
to prop up growth and inflation.
That may be just the start. At its March meeting, ECB
President Mario Draghi said its sense of urgency was over.
Investors have begun to anticipate interest rate rises by the
end of this year.
"DRUGS DON'T WORK"
Some analysts warn that if the ECB tries to wind down its
programme quickly, borrowing costs for so-called peripheral
countries relative to Germany -- known as the spread -- could
widen by as much as 1-2 percentage points.
For the likes of Portugal that would put borrowing costs
back towards levels seen as unsustainable for managing debts.
In a similar way that some emerging countries suffered in
the backdraft of U.S. hints it would scale back monetary easing
in 2013, the bloc's weakest links may be punished by markets.
"The drugs don't work already and when you take steps
towards pricing in less drugs – QE – then you price in spread
widening," said Richard McGuire, head of rates strategy at
Spain and Italy have been among the poorest performing bond
markets in the euro area this year. reut.rs/2mYpNZU
The German/Italian 10-year yield gap this week rose above
200 basis points to its widest in three years.
There was little change in these spreads last week's Dutch
election. Investors say French bonds could win some respite if
the eurosceptic Marine Le Pen is defeated in May's presidential
But it is unclear whether the same is true for the debt of
Italy and Portugal, where governments have struggled to
implement structural reforms and shore up a fragile banking
"As the ECB gradually withdraws monetary stimulus this year
and next, that will place a disproportionate challenge on the
weaker countries to grow under the tighter monetary stance,"
said Andrew Bosomworth, head of portfolio management in Germany
at PIMCO, one of the world's largest bond investors.
"Hence we see valuations in peripheral countries as
vulnerable, especially if they do not or cannot compensate for
less monetary stimulus with stimulative fiscal policy or
growth-enhancing structural reforms."
Election uncertainty in the euro zone has also been weighing
down market inflation expectations in the bloc.
Analysts say those expectations should snap back once the
political hurdles are cleared, meeting the ECB's near 2 percent
target and supporting the case for tighter policy.
For the currency market, some argue the prospect of tighter
policy is set to prove as least as important as politics over
the next six months.
Bets against the euro hit their lowest in nearly a year
after this month's ECB's meeting and major banks have abandoned
predictions for a fall to parity with the dollar.
"Politics is always only part of the equation and ECB policy
is certainly as important, if not more important, for euro zone
bond markets," Valentijn van Nieuwenhuijzen, chief investment
strategist with Dutch financial group NNIP said.
"If the underlying backdrop in terms of growth, earnings,
inflation is actually surprising to the upside. Politics are a
sideshow rather than a driver of markets."
(Graphics by Alasdair Pal and Nigel Stephenson; Editing by