The Wall Street Journal reports, "Italian and Spanish 10-year yields have both fallen by more than 0.6 percentage point this year, to just under 3.5%, and are now at levels not seen since early 2006. In Portugal, the rally has been even sharper: 10-year yields have fallen more than a percentage point and five-year yields by about two points. That is generating strong returns. Italian bonds are up 3.5% year-to-date, according to Barclays indexes, while Spain is up 4% and Portugal 7.7%".
Importantly, the investor base for euro-zone government bonds is deepening. At the peak of the euro-zone crisis, domestic banks took the strain and massively increased their home-sovereign bondholdings. But while Italian banks marginally reduced their holdings of Italian government bonds in January, according to European Central Bank data, yields still fell sharply, indicating interest from other buyers. Spanish banks did add €18.1 billion ($24.77 billion) of domestic government bonds, but holdings are still well below their 2013 peak. Encouragingly, French banks, which dumped non-French government bonds as the crisis ramped up in 2011, added €14.6 billion of non-French bonds in January. Greater cross-border flows would be a sign of healing in Europe's bond markets.
So far, bond investors don't seem worried about low inflation, which stands at just 0.8% in the euro zone. Low inflation or deflation would normally be a bond investors' friend—but it makes the process of economic adjustment harder, and may yet lead to concerns re-emerging about the sustainability of some European governments' debt loads. The ultralow inflation levels in southern Europe also mean that governments are still paying relatively high real debt yields.
But the broadening of investor demand, along with Europe's gradual recovery, means that euro-zone government bonds could yet offer further gains. In Italy, there is hope that new Prime Minister Matteo Renzi will succeed in introducing reforms; in Spain and Portugal, there are signs that structural reform is paying dividends in growth. Credit ratings have started to move higher again after several years of steep downgrades.
Ultimately, too, euro-zone bond investors are sheltered from the debate about monetary policy tightening that is under way elsewhere. Those hoping for radical easing from the ECB may yet be disappointed, as none of the central bank's options come without drawbacks. But investors can be sure the ECB won't be tightening policy for a long time yet.
