Italian bonds surge as government talks make progress

Italian government bonds rallied on Tuesday, pushing 10-year yields to fresh three-year lows on signs of progress in talks between the Democratic Party (PD) and anti-establishment 5-Star Movement to form a new government.

In a day of volatile trading, Italian bond yields were driven by the latest headlines on the coalition talks. Government talks between the 5-Star and the PD have made progress, PD Senate leader Andrea Marcucci said.

Five-Star meanwhile said it welcomed signs of the PD's willingness to accept a return of Giuseppe Conte as prime minister and it wanted to resume talks to form a government. This sparked a renewed fall in Italian bond yields, which had risen earlier on signals that the talks were stalling.

Italy's 10-year bond fell 21 basis points on the day to 1.124%, its lowest in three years. It was on track for its biggest daily fall since early July. Across the curve, Italian bond yields were down 13-19 bps on the day, while the 10-year bond yield gap over safe-haven Germany was at its tightest in a month at around 181 bps.

"In so far as the BTP/Bund spread is concerned, the market likes what it's hearing because it removes the uncertainty of elections and the outcome of a government that could be feisty with the European Union," said John Davies, G10 rates strategist at Standard Chartered. Italy's blue-chip stock index hit its highest in more than three weeks on the comments from the PD's Senate leader and was last up 1.6%.

Both Italian bond and stock markets outperformed their regional peers. Earlier in the day, the talks between 5-Star and the opposition PD ran into trouble as the parties traded accusations over key jobs, including that of interior minister.

Bond yields in Italy have mirrored their global counterparts as a rush to perceived safe-haven assets among growing concerns of a trade conflict between the United States and China have pushed yields lower. So far this year, Italian 10-year bond yields have dropped more than 160 bps from 2.90% at the start of the year.

President Sergio Mattarella has given 5-Star a chance to avert a snap election by forming a new coalition with the PD. Last week he told them to report back by Tuesday, but on Monday he extended the deadline to Wednesday. Core European government bond yields edged lower with 10-year German bond yields at -0.69%, not far from a record low of -0.73% hit earlier this month.

Global trade tensions have stoked concern about the growth outlook this year, pushing bond yields in the euro area deep into negative territory as investors bet on central bank action to shore up growth and inflation. Investors have ramped up bets of more policy easing from the European Central Bank with money markets expecting about 13 bps in interest rate cuts at its next policy meeting in September.

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