LONDON: The premium investors demand to hold Italian debt over Spanish hit its narrowest level in over a year on Friday and was half what it was just six weeks ago as bond markets priced out political risk in the euro zone.
Analysts believe a change in Italy's electoral law reduces the chances of a populist victory in next year's election, while Madrid's decisive approach to shutting down Catalonia's bid for independence has won the approval of bond market investors.
In general, investors have piled into Southern European debt recently and Italian, Spanish, Portuguese and even Greek borrowing costs have all fallen sharply over the past month.
Analysts say the market is welcoming what it sees as a waning of political concerns in the euro zone against a backdrop of still-easy monetary policy.
"Whether it is justified or not, the market is not worrying about the Italian political scene at the moment and, on the other hand, there are hopes that the fundamental situation is improving, with higher growth and less pronounced problems in the banking sector," said DZ Bank strategist Daniel Lenz.
"The overall situation of improving growth numbers in the euro zone, in combination with the ECB sticking to their expansionary path, is very positive for peripheral spreads."
Earlier this year, Italian polls suggested that the anti-establishment 5-Star Movement could take advantage of growing scepticism towards the single currency and make gains in next year's election.
This, in combination with concerns over a possible withdrawal of stimulus by the European Central Bank, pushed the Italian 10-year bond yield spread over Germany's to 180 basis points, and the spread over Spain to over 60 bps, in September and October.
On Friday, the Italy/Germany spread was at 142 bps and the Italy/Spain spread at 30 bps -- both their narrowest levels in well over a year.
Euro zone government bond yields plummeted last week after the ECB said it would extend its asset purchase programme until at least September 2018, albeit at a reduced pace.
Italian debt -- seen as one of the biggest beneficiaries of ECB largesse -- has been a particularly strong performer since, a trend that accelerated after a surprise ratings upgrade from S&P and the approval of a new electoral system.
Most other euro zone bond yields held on to recent gains on Friday after US President Donald Trump appointed Federal Reserve Governor Jerome Powell, seen as marginally more dovish than other candidates, the new head of the US central bank.
The yield on Germany's 10-year government bond, the benchmark for the region, was unchanged at 0.37 percent, a touch off recent lows but still well below last week's high of 0.48 percent.
Non-farm payroll data from the US due later on Friday could inform the pace of future rate hikes, though most analysts now expect the Federal Reserve to hike rates for the third time this year in December.
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