Euro zone yield spreads stabilize, French election result under pressure

© Reuters. FILE PHOTO: The European Central Bank (ECB) displays the new 50 euro note at the bank’s headquarters in Frankfurt, Germany, July 5, 2016. REUTERS/Ralph Orlowski/File Photo

Stefano Rebaldo

(Reuters) – Core and peripheral euro zone bond yields fell between core and peripheral euro zone bond yields amid tepid concerns over France’s political outlook after President Emmanuel Macron lost control of parliament in parliamentary elections Spreads stabilized on Monday. Meanwhile, German yields continued to rise as investors remained concerned that the central bank was ready to fight inflation with whatever interest rate pain was needed.

European Central Bank President Christine Lagarde reiterated on Monday that she plans to raise the ECB’s interest rate twice this summer while dealing with a widening spread in the borrowing costs of different euro zone countries.

The ECB triggered a sharp narrowing of yield spreads last week after agreeing to rein in borrowing costs in the southern part of the euro zone. Germany’s 10-year government bond yield rose 4 basis points (bps) to 1.7% on Monday after hitting its highest level since January 2014 at 1.926% on Thursday. In less than a month, Germany’s benchmark borrowing cost rose from around 1% to 1.9%. French bonds underperformed slightly after Sunday’s election setback, which will force Macron to negotiate a coalition with other parties. French 10-year bond yields rose 5 basis points to 2.251%, while the spread with Germany widened by 1.5 basis points to 54.5 basis points. Andrew Mulliner, head of global integrated strategy at Janus Henderson, said: “The bond market is not very sensitive to this (French politics) as it is watching the ECB’s next move to avoid excessive widening of the spread between the core and the periphery.” Some analysts say Macron’s reform plan is challenging, even with a parliamentary majority backing him. Holger Schmieding, an economist at Berenberg, said he “has long believed that Macron’s reforms will make France the most dynamic major economy in the EU ahead of Germany, which is likely to remain largely on track”. Italian 10-year government bond yields rose 2 basis points to 3.696%.

The spread between Italian and German 10-year bond yields narrowed 0.5 basis point to 198.5. It tightened from over 250 basis points to below 200 basis points late last week after the ECB announced a new anti-fragmentation tool to prevent excessive differentiation of borrowing costs across countries.

The spread between Spanish and Portuguese bond yields was also near Friday’s level.

Analysts also want to know the impact of more peripheral bond purchases to control spreads on euro zone monetary policy.

“If tools to avoid over-diversification are effective, the ECB will be free to tighten monetary policy and fight inflation without fear of widening spreads,” argues Janus Henderson’s Mulliner.

“Certainly, the ECB needs to sterilize the impact of the new peripheral bond-buying program to avoid an unnecessary increase in liquidity,” he added.

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