Lex: Sovereign credit spreads

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Italy is a lot like Germany. Not in culture or climate, but in its 10-year government bonds, which yield much the same as those of its northern neighbour.

In recent years, the search for yield has taken precedence over sovereign credit downgrades and breaches of fiscal rules. Italy’s downgrade in 2004 had little effect on yield spreads. French and Dutch rejection of the European Union constitution and the emasculation of the stability and growth pact had a slight impact last year, but spreads remain very tight. Italian10-year bonds yield only 20 basis points more than German Bunds.

Pressure for spreads to widen, however, is increasing. The European Central Bank has started to raise interest rates. As excess liquidity is gradually removed, bond investors should become more discriminating. In November, the ECB made explicit which bonds it would accept as collateral. Italian bonds are currently sufficiently highly-rated, but the ECB’s action is a reminder that holding them is not a form of risk-free yield enhancement.

Economic fundamentals differ. The German economy only grew by about 1 per cent in 2005, but Italy flirted with recession. Germany will increase VAT next year, while Italy’s fiscal outlook, with an election in April, is more uncertain. Morgan Stanley, meanwhile, highlights the sharp increase in eurozone government issuance expected in the first quarter, which is far more marked in Italy than Germany. The extent is unlikely to be dramatic, but yields should diverge this year.

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