Spain, Italy yields fall as ECB speculation grows

LONDON: Spanish and Italian bond yields fell sharply on Tuesday with investors expecting the ECB to detail a plan to tackle the debt crisis, but demand for lower-risk paper remained solid given uncertainty over the scheme.

Speculation over the scope of a potential European Central Bank bond-buying scheme grew after President Mario Draghi was quoted late on Monday as saying ECB purchases of sovereign bonds with maturity of up to three years would not breach European Union rules against directly financing euro zone governments.

Short-dated Italian and Spanish debt led the falls in peripheral bond yields but traders said an acceleration of the move was unlikely before the ECB's meeting on Thursday given uncertainty over the size of the bond-buying scheme.

Questions also remained over whether ECB policymakers will unanimously back the scheme, opposed by the head of Germany's influential Bundesbank, Jens Weidmann.

"Markets are taking a bit of confidence from Draghi," said Brian Barry, a strategist at Investec.

"There's scope for further steepening of Italian and Spanish curves but we haven't seen the colour of the ECB's money and given questions over what exactly is going to come out of the ECB meeting, it's difficult to say how far it will go."

Spanish two-year yields dropped to their lowest since early April at 3.10 percent as investors welcomed Draghi's reported comments, while their Italian counterparts fell to five-month lows of 2.4 percent.

"We've seen a couple of investors doing a bit of asset allocation back into Spain, for the first time in a long time," one trader said. "It's reducing underweight positions rather than going long, I'd guess, but it makes for a better backdrop for Thursday's auctions."

Spain will sell up to 3.5 billion euros of bonds with maturities of up to four years on Thursday.

Spanish 10-year yields fell 27 bps to 6.62 percent with their Italian counterparts a more modest 11 bps lower at 5.68 percent.

RBS strategists affirmed their target of Spanish two-year bonds falling to 2.20 percent in coming weeks on the back of ECB intervention.

"This is risk-on as the probability of an error by the ECB in buying only very short-end paper has receded and we remain comfortable holding longs in two-year and shorter-dated Spanish bonds," RBS strategist Harvinder Sian said.

DEMAND FOR LOWER-RISK PAPER

The rally in the periphery did not have a marked effect on demand for bonds issued by the euro zone's stronger countries.

Austria sold bonds at a record low rate, a day after Belgium did the same. And although German Bund yields are off all-time lows, it will offer a 1.5 percent coupon on new 10-year bond on Wednesday - the lowest to date. "The ongoing optimism as regards support for the periphery isn't proving a zero-sum game at the moment," said Rabobank rate strategist Richard McGuire.

"It's not to the detriment of core issuers, partly because we need to see details of the plan. This is quite a good window of opportunity for the triple-As ahead of the ECB meeting and Thursday's Spanish bond auction."

Tking advantage of market conditions, the Netherlands said it would issue a three-year new dollar-denominated bond on Wednesday, with a coupon of just 0.25 percent.

"No one really knows what the landscape is going to be like after Thursday, and if we see much more of a rabbit than two ears poking out of the hat it may be a much less conducive environment for the triple- or even double-A rated issuers," McGuire added.

German Bund futures settled 5 ticks lower at 143.50. Ten-year bond yields were up 1.5 bps at 1.39 percent.