LONDON: Spanish and Italian bond yields fell on Friday as sentiment toward riskier assets improved thanks to plans for coordinated central bank liquidity injections to help stabilise markets if Sunday's Greek elections cause turmoil.
The prospect of easy access to central bank cash helped settle nerves ahead of Sunday's Greek vote which could put Athens on a path to exit the euro zone if parties opposed to the conditions of Greece's international bailout come to power.
"It's having a good impact... on the bond side we see Spanish yields turning lower. It tells us that central banks at least won't let markets collapse on Monday," said Emile Cardon, market economist at Rabobank in Utrecht.
After reaching a euro-era high above 7 percent on Thursday, Spain's 10-year bond yield eased 6 basis points from its closing level to 6.90 percent, while Italian yields fell 15 bps to 6.01 percent.
Bund futures were up 5 ticks at 141.88, recovering after a fall in late trading on Thursday when Reuters reported that major central banks were ready to pump in liquidity, if needed, to prevent a credit squeeze.
Traders said thin Friday trade was making markets volatile, with many investors having taken neutral positions and deciding to sit out the session and await the Greek election results.
"It's very hard to do anything in the Bund. It's just shooting around 20 ticks at a time, which is a sign that a lot of desks are either taking less risks themselves or have been told 'stop taking risk until after the election'," a trader said.
With few investors holding large positions, the potential for a flood of fresh activity next week was high. This could send Bunds spiking higher if anti-austerity parties claim victory and spark a renewed flight to quality.
"If we don't get a pro-bailout administration the bid to Bunds will return, absolutely. It's more than likely we'll take out the highs," said Padhraic Garvey, strategist at ING in Amsterdam.
Bund futures hit a record high of 146.89 in early June.
The alternative scenario of a pro-bailout victory - Garvey's base case scenario - would see Bunds sell off, but the potential for a huge reallocation out of safe-havens was limited by the elevated risk still surrounding Spain and Italy, he said.
PERIPHERY PRESSURE HIGH
Some of the intra-day relief in Italian and Spanish debt was due to speculative traders buying back bonds to close out short positions that profit when prices fall, traders said.
"People had probably gone quite short (on Italy) after the moves this week on Spain, so I'd expect, with the weekend coming up, people don't want to be short risk and are squaring up," the trader said.
In the medium term, Spanish debt was expected to stay under pressure despite the liquidity contingency plans, analysts said.
The agreement of a 100 billion euro rescue for Spain's banks has sparked concerns about whether existing bondholders would be pushed further down the queue for repayment, denting appetite for new debt and driving borrowing costs toward unsustainable levels.
"Spain is still in deep trouble, let's not forget that. It has fundamental problems so liquidity to help hold things together doesn't really solve that," a second trader said.
On Thursday, 10-year Spanish bond yields hit 7 percent for the first time since the launch of the euro. The breach of this level raised expectations that the country would be cut off from funding markets and forced to seek a bailout for public finances on top of the agreed banking rescue.
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