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Italy-Spain yield spread shrinks as politics discounted

By Abhinav Ramnarayan

LONDON, Nov 3 (Reuters) – The premium investors demand to hold Italian debt over Spanish peers hit its lowest level in over a year on Friday and was half what it was just six weeks ago as bond markets priced down political risk in the euro zone.

Analysts believe a change in Italy’s electoral law reduces the chances of a populist victory in next year’s election, while Madrid’s tough approach to shutting down Catalonia’s bid for independence has won the approval of bond market investors.

In general, investors have piled into Southern European debt recently. Italian, Spanish, Portuguese and Greek borrowing costs have all fallen sharply over the past month.

Analysts say the market is welcoming what it sees as a waning of political concerns in the euro zone against a backdrop of still-easy monetary policy.

“Whether it is justified or not, the market is not worrying about the Italian political scene at the moment and, on the other hand, there are hopes that the fundamental situation is improving, with higher growth and less pronounced problems in the banking sector,” said DZ Bank strategist Daniel Lenz.

“The overall situation of improving growth numbers in the euro zone, in combination with the (European Central Bank) sticking to their expansionary path, is very positive for peripheral spreads.”

Earlier this year, Italian polls suggested that the anti-establishment 5-Star Movement could take advantage of growing scepticism towards the single currency and make gains in next year’s election.

This, in combination with concerns over a possible withdrawal of stimulus by the ECB, pushed the Italian 10-year bond yield spread over Germany’s to 180 basis points, and the spread over Spain to over 60 bps, in September and October.

On Friday, the Italy/Germany spread was at 142 bps and the Italy/Spain spread at 30 bps — the narrowest levels in well over a year.

Euro zone government bond yields tumbled last week after the ECB said it would extend its asset purchase programme until at least September 2018, albeit at a reduced pace.

Italian debt — seen as one of the biggest beneficiaries of ECB largesse — has been a particularly strong performer since, a trend that accelerated after a surprise ratings upgrade from S&P and the approval of a new electoral system.

Most other euro zone bond yields held on to recent gains on Friday after U.S. President Donald Trump appointed Federal Reserve Governor Jerome Powell, seen as marginally more dovish than other candidates, the new head of the U.S. central bank.

Latest U.S. non-farm payrolls data also helped push bond yields in the bloc down.

U.S. job growth accelerated in October after hurricane-related disruptions hurt employment in September, but there were signs that labour market momentum was slowing as annual wage gains sharply retreated.

Germany’s 10-year bond yield dipped to a seven-week low at 0.35 percent. Other bond yields were also slightly lower on the day.

(Reporting by Abhinav Ramnarayan; Additional reporting by Dhara Ranasinghe; Editing by Jeremy Gaunt)

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