LONDON: Benchmark Italian bond yields stalled near three-year lows on Monday as investors geared up for a showdown between Italy's coalition partners this week.
The far-right League and anti-system 5-Star Movement have been at each other's throats for months, but tensions have risen even further recently with each accusing the other of betrayal and bad faith.
League leader Matteo Salvini warned last week he would quit the 14-month-old government unless 5-Star dropped its opposition to projects close to his party's heart, including a drive to hand greater autonomy to the League's wealthy northern heartland.
But some market strategists say the confrontational tone adopted by Salvini may be an excuse to extract greater concessions in the upcoming budget discussions.
"We are less convinced that the coalition may be about to collapse, that is because Salvini knows he has a strong hand and that is what he is trying to exert currently with the prime minister and [coalition partner] Luigi di Maio," said Matt Cairns, rates strategist at Rabobank.
Yields on 10-year maturities for Italian government debt steadied at 1.62%, within sight of an October 2016 low of 1.51%.
Bond yields have dropped by more than 100 basis points since mid-June when ECB chief Mario Draghi flagged the bank was preparing to embark again on monetary stimulus.
But the bond rally came to a halt last week as political tensions took centre stage.
Prime Minister Giuseppe Conte is due to hold another round of consultations on Monday and has said he hopes to present a final proposal on the reform to a cabinet meeting pencilled in for Friday.
"We need to watch for more developments on the Italian political situation," said Daniel Lenz, a rates strategist at DZ Bank in Frankfurt.
Short-dated Italian bond yields see-sawed, with two-year yields down 2 basis points on the day at 0.02%.
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Elsewhere, core European bond yields paused for breath after posting their biggest weekly drop in seven weeks before a European Central Bank policy meeting this week where policymakers might unveil plans for more rate cuts.
Though hopes have grown that the ECB might cut its deposit rate as soon as Thursday to soften the impact on the euro from a much-awaited Fed rate cut, market watchers say policymakers will change forward guidance before taking further steps.
Money markets are assigning a 51% probability of a 10 basis point deposit rate cut, with a Reuters poll expecting the ECB to change its forward guidance towards more easing this week and move to cutting interest rates only in September.
As a result, German bond yields for 10-year maturities were broadly steady at minus 31 bps in early London trading -- within striking distance of a record low of minus 40 bps hit earlier this month.
Ongoing tensions between Britain and Iran over the seizure by Iran of an oil tanker is also set to sustain demand for safe-haven core European debt.
Primary market activity is likely to remain slow with only Belgium and Italy due to sell bonds this week. Net issuance of 4.5-6 billion euros ($11.78 billion) is expected to be more than offset by inflows from redemptions and coupon payments, according to strategists at Unicredit.
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