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Italy's bond market cheers sign of budget deal with EU

LONDON: Italy's two-year bond yield hits its lowest level in almost seven months on Wednesday, after an Italian official

December 19, 2018

LONDON: Italy's two-year bond yield hits its lowest level in almost seven months on Wednesday, after an Italian official said that Rome had struck a deal with the EU Commission over the contentious 2019 budget.

The news, which broke late Tuesday, signals an end to weeks of wrangling that had shaken bond markets. A source in Prime Minister Giuseppe Conte's office said a deal was not expected to be formalised until a meeting of EU commissioners on Wednesday.

After initially refusing to budge on its expansionary budget plans and launching verbal assaults on EU commissioners, Italy's populist government relented last week and submitted a revised plan, including a deficit target of 2.04 percent.

That is down from the original budget deficit target of 2.4 percent of gross domestic product (GDP) in 2019, up from 1.8 percent this year, which was rejected by the European Commision for breaching EU fiscal rules.

Relief that the budget saga may be drawing to a close was evident in the bond market.

Italy's two-year bond yield slid 14 basis points to 0.395 percent, its lowest level since late May -- when Italy was gripped by a political crisis that on May 29 sparked the biggest one-day jump in two-year yields in 26 years.

Five-year Italian bond yields fell to 1.804 percent, the lowest since September and 10-year yields slid 16 bps to 2.78 percent.

"Everyone was expecting an agreement to be reached, but many people were expecting this to come in Q1 or Q2 next year," said Commerzbank rates strategist Michael Leister.

"With risk sentiment stabilising this morning, it looks like the momentum can increase in Italian bonds."

The Italian/German 10-year bond yield gap meanwhile narrowed to around 255 bps, the tightest since late September . That spread stood at 268 bps in late Tuesday trade.

Analysts noted that because that spread had come in sharply in the past two weeks on hopes of a budget deal, further tightening was likely to be limited for now.

"Some caution is still warranted," analysts at UniCredit said in a note.

"First, there are still no details available on the agreement. Second, spreads have come down significantly since mid-November ... which increases the risk of a sell-the-fact reaction. Third, the first months of 2019 will be challenging for Italy from a funding perspective."

Outside Italy, yields in broader eurozone bond markets  crept up but investors were generally sidelined ahead of a U.S. Federal Reserve rate decision later in the day.

The Fed Reserve is expected to raise interest rates, but may cut the number of hikes it anticipates next year and signal an earlier end to its monetary tightening in the face of financial market volatility and rising recession fears.

Copyright Reuters, 2018