Italy yield gap over Germany widest in two months as S&P review nears

Italy's bond yield spread over Germany reached its widest in two months on Friday, before a ratings review that could see Italy downgraded to within a notch of junk territory. S&P Global will review of Italy's sovereign credit rating after the market closes on Friday. It currently rates Italy BBB with a negative outlook. A downgrade to BBB- would put the rating just one level above junk. Italy is rated Baa3 by Moody's and BBB by Fitch.

"What will be tricky about this review is that even if S&P does not have enough to justify a downgrade, the wording could give us an idea of where the rating is going in the next six months," said Natixis rates strategist Cyril Regnat. "The (Italy/Germany bond yield) spread at the moment is close to another technical level - it will be interesting to see what happens if it hits the next ceiling of 275 basis points," he said.

That spread, often seen as a barometer of investor sentiment towards the euro zone, was at its widest in two months on Friday at 270.7 basis points. It actually came off that level slightly as the session wore on, and Italy's 10-year yield was lower 2 basis points on the day at 2.67 percent; but only after having risen 28 bps over the past two weeks before that.

Italy is not the only Southern European bond market under pressure. Spain's 10-year bond yield spread over Germany was near its widest in three weeks at 110 bps, before an election this weekend that's one of the most contentious in decades. At least five parties have a chance of being in the next government. The far-right party Vox is likely to win seats for the first time.

Yet the effect so far has been limited, and analysts attribute this to the country's underlying economic strength. "Spain has so far avoided a populist government, kept the country together, tackled corruption, and 67% of the population has a favourable opinion of the EU," analysts at asset management firm Indosuez Wealth Management said in a note.

"As long as Vox does not enter a governing coalition, the Spanish elections could actually deliver a fillip to European markets." S&P is also due to review Greece's rating, currently B+, later on Friday, and a positive outlook suggests it may be upgraded.

German 10-year Bund yields, the benchmark for the euro zone, remain below zero as worry persists over the region's economy. Gross domestic product data from the United States due later today could further highlight the growing divergence between the economies of the two regions.

Overnight, European Central Bank vice-president Luis de Guindos said the bank is prepared to resume its money-printing programme if necessary to boost inflation, but so far it has not discussed such an option. (Reporting by Abhinav Ramnarayan; Editing by Toby Chopra)