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Spain and Italy rebound but rocky road lies ahead

By William James

LONDON (Reuters) - Spanish and Italian bonds rebounded on Tuesday after a steep selloff in the previous session, signaling the start of what analysts expect will be a volatile period fuelled by political uncertainty.

Yields on both countries' debt dipped as markets took stock of corruption allegations in Spain, which are pressuring premier Mariano Rajoy, and of growing uncertainty over how upcoming elections in Italy might pan out.

Spanish 10-year yields fell 8 bps to 5.37 percent and Italian yields slipped 3.3 bps to 4.45 percent.

Both yields had risen 20 basis points on Monday in one of the steepest selloffs of peripheral bonds since before the European Central Bank's pledge to buy struggling states' bonds if needed calmed markets.

"The market was simply waiting for some kind of catalyst to switch to a risk-off mood and take some of the profits that had accumulated in January when we saw a very bullish tone in the market," said Christian Lenk, strategist at DZ Bank.

Lenk said the modest rebound on Tuesday indicated that the underlying positive mood towards riskier debt was unlikely to dissipate yet.

But, analysts said trading could be more volatile in coming weeks.

Former Italian Prime Minister Silvio Berlusconi, who left office in 2011 with Italy facing a Greek-style debt crisis, has been gaining in polls, causing jitters among investors who fear the country's reform agenda may be compromised.

Similarly, any sign that the corruption scandal in Spain could force Rajoy, who denies any wrongdoing, from office would be a blow to the country's prospects of escaping recession and funding itself without official support.

A Barclays Capital analysis on Spain, using proprietary and central bank data, showed that foreign investors who deserted the Spanish market last year had returned and much of the betting against Madrid had been scaled back.

"The broad stabilization over the past month, coupled with renewed bouts of limited pressure, are likely to be the ‘new normal' for the coming months at least," the bank said.

RELATIVE PLAY

The improved performance in peripheral debt eased demand for the safety and liquidity of German debt. Bund futures slipped nearly half a point to 142.23 - wiping out much of the gains made on Monday.

Above-expectation euro zone data also eased pressure with a business activity survey showing the region is recovering, albeit driven in large part by Germany.

Traders said the rise in German bond yields across the curve was likely to ensure a smooth auction of five-year debt on Wednesday.

"German yields are far less repulsive than they were at the back end of last year and we certainly feel as though you will see some decent demand for German paper here," a trader said.

"Bank treasuries and central banks would much rather hold (German) Bobls here than (French) BTANS given the yield compression we've had."

(Editing by Susan Fenton)

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