Portuguese government bonds outpaced their euro zone peers on Friday, with investors optimistic the three main political parties will reach a deal over the weekend to keep the country's bailout programme on track. The two parties of the centre-right ruling coalition and the opposition Socialists have given themselves until Sunday to conclude crisis talks requested by the president. The coalition easily defeated a motion of no confidence in parliament on Thursday, leaving investors optimistic.
--- Bunds ease after China relaxes bank deposit rate controls
Portuguese 10-year yields fell 18 basis points on the day to 6.92 percent, posting their biggest weekly fall since January. Five-year yields dropped 22 bps to 6.62 percent. Both yields traded above 7.50 percent last Friday. "It's been quite a rally, but you have to say volumes are extremely low," said David Keeble, global head of fixed income strategy at Credit Agricole in New York.
"The market is positioning (for a deal in Portugal) ... although these brinkmanship moments aren't the best time to go long. If there is a deal next week then you can take the 10-year and chop another 50 bps off it, even more at the short end." The gap between the price bidders were willing to pay and holders wanted to be paid was over 2.5 cents in the euro, indicating low trading volumes exacerbating the move. In most other euro zone markets the gap was less than 0.1 cents.
On such low liquidity, only a few trades could reverse the rally next week. If parties cannot reach a deal, the risk is that Portugal will have to hold early elections, and prolonged political uncertainty might complicate its plans to come back to the market next year. A failure to issue new debt could force Lisbon to request another bailout, a burden investors fear official creditors may not be willing to carry alone, raising the possibility of a Greek-style debt restructuring.
That threat would not go away completely even if parties find a compromise on Sunday, analysts said.Portugal's yield gap between 10- and five-year yields remained close to its lowest in a year, suggesting investors were still worried about the country's credit quality. "At the moment, the yields at these levels have placed a question mark over Portugal's ability to return to the market but it has not closed the door to such an outcome," said Richard McGuire, senior fixed income strategist at Rabobank.
"The evident divisions as regards austerity between the two ruling coalition partners are likely to come back to the fore before too long," he said, adding that the 2014 budget draft, which has to be presented to parliament by October 15, would likely highlight that rift. German debt, meanwhile, weakened slightly after China said it would gradually relax controls on bank deposit rates as part of a long-awaited interest rate reform which analysts said will boost growth in the world's second-largest economy.
Bund futures were last 8 ticks lower on the day at 144.15, having hit a session low of 143.99 on the news. "We have seen bond markets weakening on these headlines as interest reforms are seen as a growth support for China," said Norbert Aul, rate strategist at RBC Capital Markets. "(It) isn't a substantial sell-off. As the Chinese central bank indicated this is a gradual process, so I wouldn't read too much into the immediate market reaction at this stage."