LONDON: Portuguese bonds were stable on Friday, with investors expecting lenders to set tough bailout terms and complicate the task for the upcoming government, while Bunds fell as markets brought forward bets for the timing of the next rise in euro zone interest rates.
Euro zone finance ministers meet on Friday to discuss Portugal's aid request and are expected to ask for difficult fiscal conditions in return, keeping uncertainty high over its ability to grow out of its debt crisis.
News that the European Central Bank encouraged Portugal to seek aid and comments from finance ministers on Friday pointed to Lisbon being asked for tougher budget cuts than those whose rejection by parliament last month prompted a political crisis.
With the rally earlier this week losing steam, uncertainty will probably keep Portuguese bond yields close to Irish ones after the spread between the two narrowed by about 200 basis points since the March government collapse in Lisbon.
"I don't imagine the situation is going to be particularly rosy for Lisbon, (EU) partners have been urging them to seek a bailout for a long time ... so Portugal doesn't have a choice and there won't be an awful lot of negotiation," said Lloyds strategist Eric Wand.
ECB President Jean-Claude Trichet kept expectations for further rises this year in euro zone interest rates alive following Thursday's 25 basis point increase to 1.25 percent.
He said the bank would "monitor very closely" risks to inflation, phrasing which in the past has signaled a pause for a month before another rise, although he did soften the message somewhat by stressing Thursday's hike was not planned as the first in a series of moves.
A new hike in July is fully priced in, but the probability priced in by markets for an increase in June has risen.
"June is now looking very much possible and (it is weakening Bunds as) the ECB looks more aggressive because of that," one trader said.
The Bund future was 41 ticks lower at 120.30. Ten-year Bund yields were 4.8 bps up at 3.462 percent, while the two-year Schatz yield stood at 1.889 percent, up 6.7 bps on the day. Weakness in US Treasuries fuelled by the risk of a government shutdown after government leaders failed to reach a budget deal is also feeding into core European markets, traders said.
"Ten-year Bund yields will test 3.5 percent very soon particularly because there's also weakness in Treasuries," Stamenkovic said.
IRELAND BRIGHTER
This week's outperformance by Ireland, following a less gloomy view on its banks after the stress tests last Thursday, can be taken as a sign that Portuguese yields may surpass Ireland's in the longer-run.
"At the moment people will probably trade the two on top of each other ... but if the banking problem can be contained the Irish economy is probably more vibrant than Portugal's," said Lloyds' Eric Wand.
Irish and Greek yields had risen again after a brief dip immediately after their bailouts as markets began to price in the risk that their debt will eventually be restructured under the permanent euro zone bailout mechanism due to start operating in 2013.
The Portuguese/German ten-year bond yield spread was stable at 546 basis points.
Portugal is expected to receive aid of up to 85 billion euros, and a figure much higher than that could increase pressure on bond prices as it would point to deeper problems than previously thought.
"The market will largely shrug off any figure unless it's above 100 billion euros," said Nick Stamenkovic, bond strategist at RIA Capital Markets. "It shows the extent to which they need external assistance."
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