Spanish bond yields fell to record lows on Friday on expectations that 60 billion euros ($81 billion) worth of debt and coupon repayments from Spain and Italy will be reinvested in those markets next week. A downbeat Ifo German business survey rekindled speculation of further European Central Bank policy moves, offsetting the selling pressure on euro zone bonds that came after better than expected manufacturing and services sector surveys on Thursday.
The ECB cut all its interest rates last month and promised up to 1 trillion euros in long-term bank loans from September, but it had not ruled out an asset-buying programme eventually if inflation remains low for too long. German business sentiment fell for a third consecutive month in July, suggesting firms in Europe's largest economy are getting worried about the crises in Ukraine, Iraq and Gaza.
"The Ifo results confirm a breakdown under way in the main engine of euro zone growth, which raises the ... risk that Russia sanctions may expose weak pockets in the euro zone recovery and challenge the power of recent ECB announcements," said Lena Komileva, chief economist at G+ Economics. Spanish and Italian 10-year yields dropped 3 basis points to 2.53 percent and 2.70 percent respectively, before paring some of those gains in the afternoon.
German 10-year Bund yields, the benchmark for euro zone borrowing costs, also fell 3 bps to 1.15 percent. Based on the redemption and debt auction schedule over the summer, UBS strategists recommend buying three- and seven-year Italian bonds against five-year paper and selling three-year Spanish bonds for similar-dated Italian paper.
The rationale is that the three- and seven-year Italian bonds would benefit from the fact that repayments are larger than the amount that is likely to be sold at auctions. Italy is the only euro zone sovereign bond issuer next week, when it holds two separate auctions, but has cancelled its mid-August auction. Money markets were expected to be calmer in the coming week after a steady rise in rates in the past few days.
Data showed on Friday banks will repay only 3 billion euros of long-term loans to the ECB next Wednesday, down from 21 billion euros this week and compared with a forecast of 5.8 billion in a Reuters poll. Rabobank strategists said they expected repayments to slow in coming months as banks grow more relaxed that they can swap their current loans for the ones the ECB plans to offer from September.
"However... we would want at least two more low repayment numbers before we become really confident on this view," they said in a note. The small repayment next week should in theory keep excess liquidity in the euro zone banking system above 100 billion euros for the time being, preventing any stress in interbank markets. "We expect Eonia rates to settle into quite a narrow range," RBS rate strategist Harvinder Sian said, referring to the euro zone's overnight bank-to-bank borrowing rate.