LONDON: Portugal's government bond yields hit one-month lows on Tuesday ahead of a crucial ratings review from DBRS this week.
Portugal on Friday slashed its deficit target for 2017 to 1.6 percent of economic output from this year's estimated 2.4 percent, and a report from German newspaper Handelsblatt revived suggestions the government is planning to set up a bad bank to deal with the struggling banking sector.
Those two developments strengthened expectations that DBRS would leave the country's last investment grade rating untouched at a scheduled review this Friday. Concerns over the rating - with eligibility for the European Central Bank's asset purchase programme in the balance - has weighed on Portugal's government bonds since mid-August.
"I think the market now believes the investment grade rating should survive, and we tend to that view as well," said Commerzbank rates strategist David Schnautz.
"It remains to be seen if this is just a feel good environment or if it is justified." He sounded a note of caution, saying that it remains to be seen if the deficit target - part of the draft budget proposal for 2017 - proves feasible.
Portugal's 10-year bond yields rose from an Aug. 15 low of 2.69 percent all the way up to 3.63 percent last Monday, October 10. Since then, government comments suggesting the rating was safe and further good news have pushed yields lower.
On Tuesday, the yield on the Portugal 10-year benchmark fell 1.7 basis points to 3.25 percent, before rising again. One of DRBS's key concerns has been the Portuguese banking sector, and Handelsblatt reported on Monday the government is planning to create a bad banks to absorb its bank's non-performing loans (NPLs).
Prime Minister Antonio Costa said in April that the country needs to work with regulators to find a solution for the banking sector's non-performing loans and named a fund for bad loans as a possible option. Sources say there have been no concrete developments on that front so far.
"This is a reminder that there are issues for Portugal beyond Friday's review, and NPLs are a very difficult beast to tackle," said Schnautz. "Though the mechanics of the bad bank are still unclear, at the very least they are dealing with issue head on."
The yield on other euro zone government bonds were flat in early trading but were pushed lower as the session wore on by falling gilt yields.
The yield on 10-year gilts fell 4.2 bps to 1.08 percent, and Germany's 10-year Bund, the euro zone's benchmark, was down 1.7 bps to 0.04 percent by 1100 GMT.
"Strengthening sterling is reducing inflation expectations and gilts are leading the way again, and pushing European yields slightly lower," said Rabobank senior fixed income strategist Richard McGuire.
Sterling hit its highest against the euro since its Oct. 7 "flash crash" in a rollercoaster session on Tuesday, buffeted by mixed interpretations of a rise in inflation and suggestions parliament would have to ratify Britain's deal to leave the European Union.
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