Italian borrowing costs recover as political uncertainty looms

Italy's government bond yields fell on Wednesday to recover some of their rise from a hefty selloff a day earlier even as uncertainty over the government in Rome loomed. Italy's government was hanging by a thread on Wednesday ahead of a news conference by former Prime Minister Matteo Renzi who has threatened to pull his tiny centrist party out of the ruling coalition, triggering its collapse.

Ten-year Italian government bond yields were down 3 basis points to 0.61% on Wednesday after a 10 bps rise on Tuesday delivered their worst session since early November. Five-year Italian yields returned to negative territory after rising above zero for the first time since mid-November on Tuesday.

Although Tuesday's moves reflected political uncertainty, this has not materially raised the likelihood of a snap election, bond analysts said, and Wednesday's price action so far supported that view. Investors likely took the opportunity to take profits on Italian government bonds, analysts said, after the risk premium offered recently fell to its lowest since 2016 below 100 bps.

The closely watched gap between 10-year Italian and German yields - effectively the risk premium on Italian debt - was at 110 bps after rising to 111 bps earlier, its highest in nearly a week. "If Renzi leaves the government, it could trigger a reshuffle and a new government, but the impact on the Italian government bonds should not be long lasting," Jens Peter Sorensen, chief strategist at Danske Bank in Copenhagen, said.

"We expect the spread to stabilise as this is more on internal political noise in the Italian government rather than Italy's commitment to Europe." In higher-rated markets, benchmark German 10-year yields fell 2 basis points after rising on Tuesday in tandem with U.S. Treasuries.

Focus was also on debt sales, with Spain on track to receive record demand of 130 billion euros for a 10-year bond it is selling via a syndicate of banks. In auctions, Germany raised 4.066 billion euros from the sale of a new five-year bond, while Portugal raised 1.25 billion euros from the reopening of bonds due 2030 and 2035.

The European Central Bank is keeping a close eye on exchange rate developments and their negative impact on inflation, ECB policymaker Francois Violleroy de Galhau said on Wednesday. President Christine Lagarde also warned not to target the bloc's exchange rate, adding that the bank's forecast for economic rebound this year still stands despite fresh lockdowns in the bloc.

The Federal Reserve will also be monitored, with several speakers lined up on Wednesday as hopes for reflation under Joe Biden's upcoming administration have pushed U.S. Treasury yields higher. ($1 = 0.8201 euros)

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