Italian, Portuguese sovereign bonds outperform after Moody’s upgrades

The rating agency upgraded Portugal's long-term issuer rating two notches to A3 from Baa2 despite the political crisis triggered by the resignation of the country's prime minister. Germany’s 10-year government bond yield rose 2 basis points (bps) to 2.612%.

German borrowing costs edged higher on Monday as investors took a breather after last week's bond rally, while Italian and Portuguese bonds outperformed their peers after Moody's upgrades. Bond prices move inversely with yields. Benchmark Bund yields hit a 2-1/2-month low on Friday while money markets increased their bets on future rate cuts, fully pricing in 100 basis points of European Central Bank rate reduction by year-end. Traders trimmed those bets slightly on Monday.

Moody's on Friday left Italy's sovereign debt rating at Baa3 -- one notch above junk -- while upgrading the outlook from negative to stable. Most analysts expected no downgrade from Moody's, with some forecasting a better outlook. The rating agency upgraded Portugal's long-term issuer rating two notches to A3 from Baa2 despite the political crisis triggered by the resignation of the country's prime minister.

Germany's 10-year government bond yield rose 2 basis points (bps) to 2.612%. It hit 2.517% on Friday, its lowest level since Sept. 1. Italian bond prices outperformed their peers, with the 10-year yield falling 2 bps to 4.338%.

The gap between German and Italian 10-year yields – a gauge of risk premium investors ask to hold debt of the euro area's most indebted countries – tightened to 170.4 bps, the lowest since Sept. 21. It was last at 171.4 bps. "Moody's decision on Italy means that Italy's debt will keep its investment grade status barring a domestic political shock that markets currently see as unlikely," said Massimiliano Maxia, fixed income specialist at Allianz Global Investors.

"Today's mild bond selloff is keeping the market reaction to Moody's subdued," he added. The Portuguese yield spread hit 57.3 bps, its lowest since July 28. It was last at 58.8 bps.

"Portuguese government bonds have performed well this year and are trading relatively expensive compared to Spanish peers," said Francesco Di Bella, fixed income strategist at Unicredit, adding the Italian-German spread could tighten further. Investors are closely watching oil prices as their recovery late on Friday took steam out of the inflation relief sentiment triggered by recent U.S. economic data and added to the notion that the uptrend for bond markets remains bumpy.

Oil futures edged higher on Monday, extending gains on expectations of OPEC+ deepening supply cuts to shore up prices. These have fallen for four weeks on easing concerns of Middle East supply disruption amid the Israel-Hamas conflict. The federal statistics office said German producer prices fell in line with expectations in October on Monday, continuing a downward trend after a record fall in September.

The pricing of ECB euro short-term rate forwards (ESTR) implies 93 bps of rate cuts by December 2024, from more than 100 bps on Friday. "We believe that market pricing for cuts may strengthen in the near-term as activity surveys continue to weaken, but widely expected strength in wage growth data should begin to push expectations for the ECB to begin its cutting cycle further out, and eventually into second half of 2024," said Andrzej Szczepaniak, European economist at Nomura.

ECB ESTR forwards are currently pricing an around 70% chance of a 25 bps rate cut in April from 80% last week.

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