Italian government bond yields fell on Tuesday as attention switched from the weekend referendum to expectations the European Central Bank will contain any financial-market fallout.
Bond yields spiked on Monday after prime minister Matteo Renzi said he would resign following a defeat in Sunday's referendum on constitutional reform.
A day later, however, 10-year bond yields tumbled 9 basis points (bps) to 1.91 per cent, moving further away from last month’s 14-month highs around 2.17 per cent.
That narrowed the gap over top-rated German Bund yields, which were up 1 bps, at 0.34 per cent, to 157 bps. The spread has narrowed about 29 bps from where it stood at the beginning of last week.
Expectations that a snap election in Italy will be averted helped contain the sell-off, and hopes of supportive ECB action have driven yields even lower.
"The referendum result could put the ECB under pressure not to taper the asset purchase programme but to extend it for six months beyond March", in its current form, said ING strategist Benjamin Schroeder.
The ECB meets on Thursday, when it is expected to change the terms of its asset-purchase programme in order to alleviate a shortage of bonds and extend the programme beyond its current end date in March 2017.
As a result, most other euro zone bond yields also fell, particularly among lower-rated countries. Spain’s 10-year bond yield fell 8 bps to 1.49 per cent, while Portuguese yields tumbled 14 bps to a one-week low of 3.60 per cent .
Some investors might welcome the referendum result because it reduces the chances of the anti-establishment Five Star Movement gaining more power in the future, said Mr Schroeder.
A Yes vote would have reduced the power of Italy’s upper house, giving governments a freer rein.
Greek debt relief
Greek bond yields were little changed after euro zone finance ministers agreed some debt relief for the debt-laden nation.
Analysts said International Monetary Fund involvement in its new bailout and the inclusion of Greek debt in the ECB's quantitative easing scheme were crucial for declines in yields, which would let Greece tap bond markets again.
"We remain of the view that IMF involvement is far from a done deal, given that it will need to specify medium-term debt-relief measures to make Greece's debt sustainable within the Fund's framework, as well as full reform implementation," Barclays said in a note.
“Also, we continue to think ECB QE including Greek government bonds is not around the corner, but a window of opportunity may open in Q1 17.”
Elsewhere, the euro zone’s five-year, five-year breakeven forward rate, a market gauge of inflation expectations that is followed closely by the ECB, rose to a one-year high, at 1.7052 per cent .
