LONDON (Reuters) - The yield premium investors demand for holding Italian bonds over Germany hit its highest since January on Thursday, as two anti-establishment Italian parties moved closer to a government deal that would ramp up spending.
The far-right League and 5-Star Movement on Thursday agreed the basis for a governing accord that would slash taxes, boost welfare spending and pose the biggest challenge to the European Union since Britain voted to leave the bloc in 2016.
A 5-Star source added that the coalition programme contained no reference to a possible exit from the euro.
That bought some relief to markets, jolted on Wednesday by a draft coalition document showing plans to ask the European Central Bank to forgive 250 billion euros ($295 billion) in debt, and create procedures to allow countries to exit the euro.
“We did have quite a constructive stance on Italian bonds, driven more from a valuation perspective,” said Craig Veysey, manager of the Sanlam Strategic Bond Fund.
“But we cut it entirely a couple of weeks ago as a result of what’s turning out to be a much more fraught political situation, particularly statements about cancelling some of the outstanding Italian debt and not proceeding with pension reforms.”
Italy’s 10-year bond yield was up 5 basis points on the day at 2.14 percent, but off earlier 3-months highs of 2.18 percent IT10YT=RR. It remained on track for the biggest 2-day rise since March 2017, up 20 bps.
The Italian/German bond yield gap briefly widened to 157 basis points, its widest since early January. IT10YT=RR, DE10YT=RR.
While that spread, a key gauge of relative risks, is up from around 130 bps earlier this week, the gap remains below levels seen early last year when euro-break up fears gripped markets ahead of French elections.
During the 2010-2012 euro zone debt crisis, the Italian/German spread ballooned out to over 500 bps.
“The focus has clearly shifted for investors towards the kind of policies the new coalition government will come up with but despite the surge in Italian yields, we are still a long way from the kind of swings at the height of the euro zone debt crisis,” said Marc-Henri Thoumin, a rates strategist at Societe Generale in London.
The spike in Italian debt rippled over to other peripheral bonds at a time when concerns of a pull back in policy accommodation by the world’s major central banks and rich valuations have weighed on investors’ minds.
Portuguese 10-year bond yields briefly hit a two-month high at 1.82 percent PT10YT=RR.
In a sign that any contagion was largely limited, Spain received healthy demand from investors at a bond auction.
Spain and Greece are the best performing bond markets this year in Europe with returns of more than 2 percent each, according to Thomson Reuters data.
Elsewhere, 10-year U.S. Treasury yields hit a near seven-year high of 3.12 percent US10YT=RR, while yields on two-year maturities hit their highest since August 2008 at 2.59 percent US2YT=RR. [US/]
Reporting by Saikat Chatterjee and Dhara Ranasinghe; Additional reporting by Helen Reid; Editing by Toby Chopra