Italian bonds slide, Bunds rally ahead of EU meeting

LONDON: Italian government bonds slid on Monday as top European officials prepared for an emergency meeting surrounded by worries that the region's debt crisis was engulfing Rome.

With yield premiums for other peripheral issuers rising, safe-haven German Bunds benefited from the risk-averse sentiment, rallying to their highest levels since early December and pushing 10-year yields below 2.80 percent.

The spread of the Italian 10-year government bond yield over benchmark German Bunds hit fresh euro lifetime highs of 268 basis points as 10-year yields rose to above 5.45 percent and BTP futures sank over a full point.

"The end game is probably fiscal union because (the crisis) is just going to move from one country to the next," said Gary Jenkins, head of fixed income at Evolution Securities.

"Italy with a debt to GDP ratio of 120 percent and debt of 1.6 trillion euros is a pretty big elephant to have in the room... you have to stop the contagion getting to Italy.”

European Central Bank President Jean-Claude Trichet will attend Monday's meeting, joining other top EU finance officials to hold critical talks on Greece and the worsening situation in Italy.

It's panic stations," said a trader.

The Italian 2- to 10-year yield curve has flattened around 20 bps over the last week, a pattern seen with previous stressed peripherals as markets begin to price in a credit premium.

While Jenkins points out that Italy is still a long way from the tipping point in terms of bond yields -- markets have focussed on yields of 7 percent being unsustainable -- recent experience shows how quickly things can get out of control.

Greece, Ireland and Portugal Spent an average 43 consecutive days trading over 5.50 percent before they went north of 6.00 percent on a consistent basis, Jenkins said.

That fell to an average of 24 consecutive days before rising above 6.50 percent, and just 15 days before the 7.00 percent level was breached on consistent basis.

Spanish 10-year yields were 15 bps higher at 5.84 percent, the highest levels since early 2000.

Italy's government -- with the highest sovereign debt ratio relative to its economy in the euro zone after Greece -- has scrambled to present a united front and defend its embattled economy minister.

"The unfolding political scandal could lead to a significant further repricing of Italy as the country becomes more deeply embroiled in the sovereign debt crisis," Nomura rate strategists said in a note.

"The potential downside (for Italian debt) is profound should the country be reclassified as a more peripheral market."

September Bund futures rallied to their highest levels since the end of November at 127.99 and were last 41 ticks higher at 127.86.

Societe Generale's technical analysts said a break above the late June high of 127.57 calls for a rise to the upper end of the medium-term rising channel, which comes at 128.71 today.

Ten-year Bund yields were almost 4.5 basis points lower at 2.787 percent with two-year yields over three basis points lower at 1.423 percent.

Copyright Reuters, 2011