Tailwinds for euro periphery bonds

Mario Draghi’s appointment as prime minister last February has brought some welcome stability to Italy and increased confidence in the country. We expect Draghi to remain in place until the end of his term in 2023, continuing to deliver on an unprecedented reform agenda in the meantime. This should help to support Italian bonds, while euro peripheral bonds in general should benefit from the roll-out of Next Generation EU (NGEU), the EU’s major recovery initiative.

The aim of Next Generation EU is to repair the damage done by the pandemic but also to make Europe greener, more digital and more resilient to future crises. By boosting potential growth, the fund represents a unique opportunity for countries to improve their debt sustainability.

In contrast with German Bunds, peripheral euro area bonds continue to offer positive yields. A winding down of the European Central Bank’s (ECB) emergency bond purchases could soon be announced, sending euro area government bond yields slightly higher by year’s end, thus underpinning our underweight stance on euro government bonds overall. But we are relatively more constructive on periphery government bonds given higher yields and the potential for further spread tightening, supported by reduced political uncertainty and the ECB’s continued presence in the euro government bond market. The ECB’s eagerness to maintain favourable financial conditions and the remoteness of rate hikes means we expect euro periphery bond spreads over Bunds to remain relatively tight.

In short, higher yields together with tighter spreads could cushion the performance of peripheral bonds should our scenario of a rise in euro government bond yields materialise.

As the ECB made clear earlier this month, even after it starts to taper its emergency bond purchases, it stands to remain very dovish and is likely to be patient on rate rises as it strives to achieve its medium-term inflation target. Mindful of this target, it is unlikely to end its asset purchases in the foreseeable future. While they could slow significantly in 2022, we still expect the ECB’s purchases of government bonds to exceed net issuance for the third year running in 2022, meaning that its share of government bonds outstanding should continue to increase.