Demand for Southern European government debt jumps after EU recovery plan proposal

Southern European bonds rallied on Wednesday, pushing yields down to their lowest in around two months, following a report that the European Commission wants to mobilise 750 billion euros for the post-coronavirus economic recovery. The riskier debt rallied after reports on Wednesday morning that the European Commmission will propose 500 billion euros in grants and 250 billion euros in loans as part of the coronavirus recovery package.

The rally eased off somewhat then regained momentum when the early reports were confirmed, with the European Commission proposing a package worth in total 1.85 trillion euros for the EU's next long-term budget along with the recovery fund for economies hammered by the coronavirus pandemic. Hopes for a co-ordinated fiscal response to the coronavirus crisis have boosted demand for riskier Italian government debt since France and Germany first made the proposals for a 500-billion-euro recovery fund.

But it was unclear if the plan - which represents a step towards fiscal union in the bloc - could come to fruition after northern European countries Austria, Sweden, Denmark and the Netherlands, which are seen as more frugal, stated their opposition. "This is supportive for risk sentiment in European fixed income," said Peter Chatwell, head of rates strategy at Mizuho.

"I would suspect that because there is a loan component in there that this is something which helps to breach the gap between what the "frugal four" were advocating, what the Franco-German proposal was advocating, and also what the real COVID-19-stricken economies actually need," he said. Italy's 10-year bond yield fell to an eight-week low at 1.463% and was last down 5 basis points on the day at 1.58% .

The German-Italian 10-year yield spread narrowed to as low as 188.75 bps. It was last at 190, down 8 bps on the day. Spain and Portugal's 10-year government bond yields fell to two-month lows and were last down 3 bps on the day .

Germany's benchmark 10-year yield hit new five-month highs when details of the European Commission's plans were confirmed . Elsewhere, European Central Bank President Christine Lagarde said on Wednesday that the euro zone economy is likely to shrink between 8% and 12% this year as it struggles to overcome the impact of the coronavirus pandemic, on Wednesday.

Antoine Bouvet, senior rates strategist at ING, said that the budgetary benefit from the fund would only be small relative to countries' needs after the coronavirus pandemic and that quantitative easing would have bigger market impact. "The headline suggest a larger package than anticipated (250 billion euros of loans on top of the 500 billion euros of grant in the Germany-France plan) however the plan still need to be discussed by the 27 members states and we know little of how the funds will be allocated between countries," he said.

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