Bonds on a roll as Italy hits EMU targets

Brave investors who placed their faith in the Italian government's commitment to qualifying for Europe's single currency have been rewarded with the best bond market returns in Europe this year - and there's more to come.

The bond rally that has delivered returns in lire of more than 28 per cent this year - ahead of the UK in second place with gains of nearly 19 per cent - has had just two cuts in official interest rates to help it along.

Last week consumer price reports confirmed that annual inflation was unchanged at 1.6 per cent in November, well below the 2 per cent ceiling demanded by the Bank of Italy. This suggests the party isn't over yet as it looks likely that the central bank will sanction more rate cuts in the coming months.

"Italian bonds are destined to rise further as Italy's entry to European Monetary Union is now certain," says Corso Pecori Giraldi, who helps manage L5,200bn (pounds 1.8bn) in bonds at Ducato Gestioni. "It's a European story, and Italian rates must come down to be a part of that story."

Italian bonds have been on a roll this year as government efforts to get its budget deficit down to the 3 per cent level demanded of countries to qualify for the single European currency from the launch date of 1 January 1999 have gained credibility.

Since November 1996, Italy has halved its budget deficit, trimming the shortfall between public spending and revenue to L10,500bn from L19,500bn.

That cut the deficit in the first 11 months of this year to L78,000bn, down from L138,000bn just a year earlier. Economists reckon that this puts Italy well on track to meet the EMU deficit target this year, and perhaps even to beat it by a whisker.

The reward for economic discipline? Italy's 10-year borrowing costs have dropped to a record low of 5.85 per cent, from about 7.5 per cent at the beginning of the year.

Moreover, the yield premium investors demand for buying Italian rather than German bonds - Europe's benchmark securities - has shrunk to a record low of 45 basis points from 200 basis points in March.

"The Italian/bund spread is destined to narrow in the coming year," says Mr Giraldi. "I see it at 30 basis points."

The approach of EMU has driven European bond yields closer together, as the bonds of countries using the same currency are expected to trade at similar levels.

Italy's performance in closing the gap to Germany, however, still lags behind that of its fellow southern European states, Portugal and Spain. Portuguese bonds yield about 36 basis points more than German issues, while Spanish yields offer a premium of about 29 basis points to Europe's bellwether market.

"Italy's been a great performance," says Sven Rump, manager at Vontobel Asset Management in Zurich. "I'm not convinced that Portugal should trade closer to Germany than Italy."

Mr Rump says he sees scope for the Italian yield premium to shed about another 10 basis points, although he feels that gains beyond that are likely to prove difficult.

Just as 10-year yield gaps are disappearing, so the differentials between official interest rates are expected to vanish. German and French central bankers are all insisting that the interest rate which will govern European monetary policy after 1999 will be closer to their 3.3 per cent level than it will to the 6.25 per cent prevailing in Italy.

Italy's discount rate has been cut twice this year, by three quarters of a point in January and by half a point in June. In September, the government unveiled a budget for next year that aims to slash some L25,000bn off the 1998 deficit and help Italy meet the single currency terms.

The bill consists of about L15,000bn in spending cuts and around L10,000bn of taxes.

The lower house of Italy's parliament is currently debating that bill, which must be approved by 31 December if it is to become law. The governor of the Bank of Italy, Antonio Fazio, has said he wants assurances that the budget will be passed before he will sanction lower rates.

With annual inflation one percentage point lower than it was at the beginning of the year, investors believe Mr Fazio might be willing to deliver a pre-Christmas rate cut as early as today.

That could be just the boost Italian bonds need to put on a final sprint into 1998.

"We could see a 50-basis-point rate cut after Thursday's inflation numbers, and another 50-basis-point cut after the budget approval," predicted Mr Giraldi at Ducato Gestioni.

q Additional reporting by Jason Jacobs.

Copyright: IOS & Bloomberg

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