Last updated: August 3, 2012 5:34 pm

Madrid and Rome’s borrowing costs dive

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Yields on two-year Spanish and Italian bonds dropped sharply as investors focused on comments from Mario Draghi that the European Central Bank “may consider” buying short-term government debt again to contain the eurozone crisis.

In secondary markets, yields on Spanish two-year government bonds fell 87 basis points to 3.96 per cent, while yields on equivalent Italian debt were down 61bp at 3.13 per cent.

There were also sizeable falls across the curve as longer-dated Spanish and Italian debt reversed gains that followed the ECB’s monetary policy meeting on Thursday.

Yields on 10-year Spanish debt were 32bp lower at 6.85 per cent, boosted by comments from Mariano Rajoy, Spain’s prime minister, that he would consider asking the eurozone’s bailout funds to buy the country’s debt.

After making strong hints that the ECB would take action last week, hopes were high among some investors that Mr Draghi would offer some immediate package of measures.

However, Spanish and Italian borrowing costs surged and markets dropped on Thursday amid disappointment that any ECB intervention would be predicated on ailing governments requesting aid from the eurozone’s rescue funds.

Analysts said Friday’s markets rally – also reflected in higher stock market rises – suggested the initial response to Mr Draghi’s comments may have been overdone and that investors were buoyed by the prospect of intervention at the shorter end of the yield curve, albeit with strict conditions.

Mr Draghi “basically said that he was considering QE [quantitative easing]. That’s a huge change and it’s targeted at the short end of the curve. For short-term trading of these bonds, it’s a game-changer,” said Gary Jenkins of Swordfish Research.

Mr Jenkins said that to a degree, the drop in yields in Spain and Italy might be “slightly premature” given that there was no sign of quantitative easing and Spain has not sought a full bailout. But he said Mr Draghi’s comments suggested a different approach by the ECB.

Spain and Italy GDP growth

Michael Krautzberger, of BlackRock, said Mr Draghi’s comments could prove “powerful”, forcing the hand of eurozone governments to act both on a country level by requesting help and on a eurozone level, making the European Financial Stability Facility or the European Stability Mechanism a viable tool.

But he said much depended on whether the conditions for ECB action were met.

Jamie Searle, fixed-income strategist at Citigroup, said he expected a steepening of the yield curve for Spanish and Italian government debt over the next few weeks, although not at the same rate as on Friday.

The next big test for investor appetite, he said, would come in early September when Spain and Italy are both due to tap bond markets.

Investors have sought out haven assets such as German Bunds throughout the crisis. With an overall improvement elsewhere in the market on Friday, Bunds were trading slightly higher.

The spread between German and Spanish or Italian bonds, however, remains sizeable. Yields on 10-year German debt were trading at 1.42 per cent.

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