BONDS : Euro doubts hit Italian bonds

Italian bonds have fallen to the bottom of the class and the outlook remains fragile with concern that European monetary union won't happen in 1999.

"Every time someone opens their mouth about EMU, Italian bonds are prone to a setback," said Johannes Mueller, fund manager at DWS Deutsche Gesellschaft fur Wertpapiersparen in Frankfurt. The next milestone will come on 17 March when EU finance ministers review their convergence plans.

Italian treasury minister, Carlo Azeglio Ciampi, will be able to point to considerable economic achievements. Inflation has fallen to a 27-year low and there were signs on Friday that the coalition government is near to making cuts to pension and welfare spending.

These gains have been overshadowed by problems in Germany where record unemploy- ment threatens to derail the deficit and leave Europe's biggest economy struggling to meet targets for the single currency.

With officials of Germany's Bundesbank publicly discussing the possibility of delaying introduction of the single European currency, Italian bonds are the world's worst-performing market in dollar terms so far this year. The benchmark 10-year bond has slumped 11 per cent.

This dismal performance is a reversal from last year, when Italian bonds were the world's best. "It's not a surprise that high-yield markets are coming back to normal valuation levels," said Ravi Shankar, director of fixed-income strategy at Zurich Investment Management.

Mr Shankar said bond values were driven up at the end of last year by "euphoria that a single currency means equalisation of credit and risk" across European government bond markets. This quarter investors are coming round to the view that the yield premium offered on Italian debt wasn't high enough to compensate for the extra risk.

Last week, a Bundesbank council member, Klaus-Dieter Kuehbacher, said Germany won't be able to meet the 3 per cent budget deficit limit to join the single currency unless the government raises taxes or cuts social security spending.

"For the positive trend of the Italian bond market to continue, we need more transparency on the Italian political situation and the future of monetary union," said Fulvio Pellegrini at Cliam Italia SpA in Bergamo. "Unfortunately, Mr Prodi can't give us any reassurance that Italy will enter EMU," the fund manager said.

The lira and the Spanish peseta have both taken a beating. "Both currencies will remain fragile as the market is taking the view that convergence trades are over," said Alfredo Urrutia, an economist at Societe Generale Strauss Turnbull.

Italian and Spanish bond yields have "converged" closer to German levels amid expectations that yields will be level once European government bonds are denominated in the euro.

"Investors should still buy Italy," Stefano Massa, at Deutsche Bank Fondi in Milan, said. "If we get positive signals about Italy's entry into EMU, I see the spread with bonds narrowing back down to between 100 and 140 basis points." Copyright: IOS & Bloomberg