March 26, 2018 / 7:32 AM / 8 months ago

UPDATE 3-New lows for Spanish borrowing costs on ratings upgrade, Italy feels some pain

* Euro zone bond yields broadly up, trade war fears ebb

* Italy underperforms on politics

* Euro zone periphery govt bond yields: tmsnrt.rs/2ii2Bqr (Updates prices)

By Dhara Ranasinghe

LONDON, March 26 (Reuters) - The premium that investors demand to hold Spanish bonds over top-rated Germany fell to six-week lows on Monday after the country’s second ratings upgrade of the year led to a further outperformance of its bond market over euro zone peers.

Bond yields across the euro area were higher as reports that the United States and China have started negotiations to improve U.S. access to Chinese markets eased fears of a trade war and reduced the appeal of fixed income.

Italian bonds were laggards amid signs that the anti-establishment 5-Star Movement and the anti-migrant League might explore an alliance to form a government.

In contrast, Spanish bonds continued to outshine their peripheral peers after S&P Global on Friday raised Spain’s credit rating to A- from BBB+, citing a positive outlook for the economy and budgetary consolidation.

Spain’s 10-year bond yield dipped to a 16-month low at 1.24 percent, before inching up slightly to 1.262 by the end of the European session. The gap over top-rated German peers was pushed to a low of 73 basis points.

The Italian/Spanish yield spread was 65 bps, close to its widest in seven months.

Spain is one of the best-returning government euro zone bond markets in 2018 as the country pushes closer to better-rated euro zone states such as Belgium, France and Ireland, referred to as the “semi-core”.

“The ratings upgrade, while backward looking, opens Spain up to a more conservative investor base,” said Patrick O’Donnell, investment manager at Aberdeen Asset Management.

“Relative to Spain, you don’t necessarily have the growth in Italy, the reforms enforced by Spain during the crisis and the near-term political risks point in opposite directions.”

The former Catalan leader Carles Puigdemont was detained in Germany on Sunday, five months after entering self-imposed exile from Spain, where he faces up to 25 years in prison for organising an illegal secession referendum last year .

FALLING BEHIND?

Italy’s 10-year bond yield rose 5 bps to a five-day high of 1.929 percent, while German Bund yields were flat at 0.526 percent by the end of trading.

The head of Italy’s 5-Star Movement at the weekend praised the League’s leader, Matteo Salvini, after the two parties agreed a deal to elect parliament’s speakers.

Asked whether his movement could side with the League to form a government in the wake of an inconclusive March 4 election, 5-Star’s Luigi Di Maio did not rule anything out .

The president is due to start formal consultations on April 3 about forming a government, but political sources have told Reuters that serious negotiations might have to wait until after regional elections slated for the end of April.

The reaction in Italian bonds to political uncertainty has been relatively muted and forthcoming bond sales may also explain weakness in Italian paper, analysts said.

“We have to wait and see because this is going to be a long-drawn out process in Italy,” said Peter Schaffrik, global macro strategist at RBC Capital Markets.

Reporting by Dhara Ranasinghe Additional reporting by Crispian Balmer in Rome and Fanny Potkin in London Editing by Larry King and David Goodman

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