South Europe bonds lag as hardliners gain in Germany

LONDON: Southern European government bonds underperformed yesterday after an unexpectedly weak election result for Germany’s Angela Merkel led to concerns about the emergence of a more hardline stance towards the eurozone in the bloc’s largest economy.

Merkel secured a fourth term as chancellor but was weakened by a surge in support for the far right and investors were unsettled by the possibility that she may have to form a coalition with the pro-business Free Democrats (FDP) and Greens - the so-called “Jamaica” coalition.

Some also said the German result could complicate the ECB’s policy path as it looks to scale back its monetary stimulus program, which has driven down borrowing costs since its launch in 2015.

“The pro-market Free Democrats, as well as part of the CDU/CSU, oppose deeper financial integration in the euro area,” analysts at Morgan Stanley said in a note. “This suggests headwinds to the euro and periphery.” The concerns come a day before French President Emmanuel Macron is due to announce his proposals for European Union reforms in a speech in Paris. Lower-rated Spanish, Italian and Portuguese government bonds sold off and 10-year yields rose 3 basis points across the board in early trade. They later clawed back the losses, but underperformed on a day when higher-rated euro zone government bond yields fell.

The Italy-Germany 10-year government bond yield spread hit its widest in 2-1/2 weeks at 168 basis points at one stage. The yield on Germany’s 10-year government bond, the benchmark for the region, hit a 10-day low of 0.42 percent, down 3 basis points on the day.

Yields on most other highly rated government bonds, such as those of Austria and the Netherlands, also fell. Demand for those bonds comes at a time when investors are also wondering what the implications of the German election are for European Central Bank policy. The ECB is largely expected to announce the end of its bond-buying scheme next month, as it seeks to unwind years of extraordinary post-crisis stimulus.

Pictet Wealth Management economist Frederik Ducrozet said the prospect of a less stable German government could lead to concerns about the eurozone economic outlook, potentially making the ECB more dovish. Rabobank strategist Richard McGuire took a different view.

“On paper, the election should have no impact on the ECB, which is an independent body,” he said. “But I think it’s fair to say if you see a ‘Jamaica’ coalition, it would not be a constructive environment to continue to provide stimulus going into next year.”

This may explain why investors are more willing to buy high-grade euro zone bonds than lower-rated Southern European ones, which are seen benefiting most from the ECB’s largesse. — Reuters