Portuguese government bond yields hit a four-month high on Monday after leftist parties reached agreement on forming an alternative government to try to oust the centre-right in a vote this week. German government bond yields reversed an earlier rise and money market rates fell after Reuters reported the European Central Bank is converging on a December rate cut, and may even consider one larger than 0.1 percent.
But the market was mainly focused on developments in the euro zone's peripheral countries. Investors worry that a deal struck late on Friday between Portugal's Left Bloc, Communist and Socialist parties, which together hold a majority in parliament, could endanger a timid economic recovery and see reforms imposed to escape a debt crisis rejected. Prime Minister Pedro Passos Coelho acknowledged his government could fall before the vote on its legislative programme on Tuesday or Wednesday which it stands to lose.
Portuguese 10-year yields rose more than 20 basis points to 2.93 percent, the highest level since mid-July and on track for their biggest daily rise in four months. There was also political uncertainty in neighbouring Spain, where Catalonia's regional government on Monday voted in favour of a breakaway resolution. That comes ahead of a national election on December 20.
Spanish 10-year yields rose 5 bps, having hit a six-week high of 2.00 percent. Lisbon's main stock index fell 3.6 percent, underperforming major European indexes, as strategists said a left-wing government with an anti-austerity bent was now likely. "The programme of the leftist coalition is clearly less market-friendly than the one of the incumbent government," said Marco Brancolini, a rates analyst at RBS, citing pledges to hike wages, re-instate bank holidays and cut tax for low earners.
Other strategists said the political upheaval in Portugal had raised the prospect of a ratings downgrade from DBRS on Friday, a move that would mean Lisbon's debt would no longer be eligible for purchase under the ECB's quantitative easing scheme. In order to qualify for QE, the European Central Bank demands that the best rating assigned by either Moody's, Standard & Poor's, Fitch or DBRS is investment grade, or a country is compliant with a bailout. DBRS is the only one of the four currently to have an investment grade rating at BBB (low) albeit with a stable trend.