Yield gap between Italian and German bonds hits 26-month low

The gap between Italian and German yields hit a 26-month low on Wednesday, as the euro area's bond prices struggled for direction, with markets still betting on around 90-95 basis points (bps) of European Central Bank rate cuts in 2024.

The gap between Italian and German yields hit a 26-month low on Wednesday, as the euro area's bond prices struggled for direction, with markets still betting on around 90-95 basis points (bps) of European Central Bank rate cuts in 2024. Bond prices move inversely to yields.

Since the ECB policy meeting last week, investors have assumed that the central bank will keep rates at the current levels until June and will gradually cut after that point. Yields on both sides of the Atlantic rose on Tuesday after U.S. inflation figures came in slightly above expectations, raising concerns that the Federal Reserve may not be able to cut interest rates as soon as investors expect.

Yields on German bonds moved slightly higher again on Wednesday but those on Italian debt fell. Germany's 10-year yield, the benchmark for the euro zone, was last up 3 bps at 2.354%, while Italy's 10-year bond yield was last down 3 bps at 3.575%.

That pushed the gap between Italian and German yields down to 122 bps, its lowest level since mid-January 2022. The spread between Italian and German 10-year yields - a gauge of risk premium investors ask to hold bonds of the euro area's most indebted countries – has fallen sharply this year as appealing returns and appetite for riskier assets boosted demand for Italian government bonds.

JP Morgan flagged, in a research note, that the yield gap was at levels seen before the ECB tightening cycle started, arguing that "the recent tightening, intra-EMU spreads, especially Italian spreads, are screening expensive relative to other Euro credit spreads". "The air is getting thin around our 125 bps target for 10y spreads, as the ISDA basis (which captures Italy's specific credit factors) is running into very hard resistances," said Michael Leister, head of interest rates strategy at Commerzbank.

The ECB would probably start cutting rates between April and June 21, as the "victory" against inflation was in sight, French central bank head Francois Villeroy de Galhau said. Money markets discounted 92 bps of ECB rate cuts in 2024 while almost fully pricing a first move by June and almost no chance of a rate cut in April.

"The longer rates remain restrictive and the slower the ECB is to cut, the bigger the danger that some economic harm becomes apparent," said Chris Attfield, European rates strategist at HSBC. "The early signs of stress are already visible in January's survey of bank lending," he added. "These tail risks are not significantly priced into the market at present."

The ECB on Wednesday unveiled the outcome of its Operational Framework Review, a technical but vital exercise that sets rules for how it provides liquidity to commercial banks in the coming years. Under the new framework, the ECB will give banks more incentive to lend to each other, while providing safety nets to limit the risk that lenders could run out of cash, including tweaking one of its key interest rates in September.

The ECB also plans to launch longer-term loans and bond-buying operations once it sees its balance sheet has started growing again as a result of banks' own borrowing. A likely implication is that future bond purchases will be focused on shorter-maturity bonds.

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