UPDATE 3-Italy bond rally cools as market digests Moody's outlook decision

The Italian bond market was headed for one of its best days on Monday since early June after Moody's did not slap on a negative outlook as the market had feared, but the rally cooled as the session wore on and stocks slipped back into the red.

Italian short-dated bond yields were still down 17-20 basis points but gave up some of the price gains made earlier in the session as the market digested a rating report by Moody's which nonetheless lowered the rating by one notch to Baa3.

The 1.5 per cent fall in Italian banking stocks also hurt sentiment, with one trader citing a report that the government has tightened a state guarantee scheme devised to help banks offload bad loans as a possible cause.

On Friday, Moody's downgraded Italy's rating to the lowest investment grade category, as expected.

But investors had fretted it would also set the outlook at "negative" following high-spending budget proposals that put Rome at odds with Brussels.

Moody's gave the outlook as stable, however, triggering a relief rally across Italian bond and stock markets.

But the rally later subsided, with analysts citing concerns that Moody’s might be willing to cut the outlook to negative during the course of next year as a driver.

"It is mostly the growth outlook which is probably the point on which Moody’s has been the most critical," said Cyril Regnat, fixed income strategist at Natixis.

He said that a downturn on Italian GDP growth might eventually warrant a negative outlook on Italy, perhaps after the first half of next year.

BENCHMARK

Italy's two-year government bond yield was last down 18 basis points having hit a two-week low of 1.42 per cent earlier in the session. The benchmark 10-year yield was 11 bps lower at 3.47 per cent.

The Italy/Germany 10-year government bond yield spread was last at 302.8 bps, having hit a low of 281.6 bps earlier in the session.

Jitters remain as the European Union is expected to ask Italy on Tuesday to revise its draft budget in what would be the first such action against a member state.

But the possibility of "Italexit" was ruled out by senior Italian politicians.

S&P Global also is scheduled to review Italy's credit rating on Friday. It now rates the country two notches above junk at BBB and has the outlook at stable.

Analyst expectations are mixed, with some expecting a one-notch downgrade while others expect only a change in the outlook to negative from stable currently.

"In our view, S&P will likely only put a negative outlook, so we might see a similar to relief rally to Moody’s as removes a possible risk (of a one-notch downgrade)," said Luigi Speranza, head of European Economics at BNP Paribas.

Should the EU decide to reject the draft budget anyway, it would formally begin a long legal dispute that will increase market pressure on Italy until it is resolved.

Fitch on Friday upgraded Cyprus's credit ratings to BBB- from BB+, the second rating agency in the space of little over a month to pull the island back into investment grade territory after a bailout in 2013. The country's 10-year bond yields were lower eight bps at 2.31 per cent on Monday.

Germany's 10-year government bond yield, the benchmark for the region, was up 1.4 pbs to 0.445 per cent.

(With inputs from agencies.)