Euro bonds advance as Merkel faces tough talks


London • German bonds climbed, while Italian and Spanish securities reversed earlier declines as it emerged that Germany’s Angela Merkel faces tough talks to form a government with a party opposed to further European Union (EU) integration.

Ten-year bund yields fell to their lowest in more than a week, while those on their Spanish counterparts dropped from the highest level since July after Merkel’s current coalition partner, the Social Democratic Party, ruled itself out of another pact following her fourth-term victory.

Merkel will have to negotiate with the Free Democratic Party (FDP) and the Green Party, which differ on issues including European reforms, and the talks may take months.

“The market reaction of bunds rallying and peripheral spreads widening makes sense after the German election result,” Antoine Bouvet, a rates strategist at Mizuho International plc, said in emailed comments.

“The prospect of prolonged uncertainty is definitely not helping. More specifically, the FDP positioning against European integration is a worry for peripheral spreads.”

Block trades in Italian and German futures were partly behind the move as risk-off sentiment spread across the continent, said traders familiar with the transactions who asked not to be identified because they are not authorised to speak publicly.

The yield spread between European peripheral debt and German securities has risen again in the past two months, after declining since the election defeat of anti-establishment parties in France and the Netherlands earlier this year reduced fears about the future of the EU.

Merkel is also likely to be challenged by the entry of the far-right Alternative for Germany party into
the country’s Parliament.

“This political constellation looks set to restrain the euro-area spread tightening in coming months,” wrote Commerzbank AG strategists led by Christoph Rieger in a note to clients.

“Larger set-backs should be seen as opportunities to add risk.”

Benchmark German 10-year bund yields fell four basis points to 0.4% as of 10:49am in London yesterday, the lowest since Sept 15.

Those on comparable Spanish bonds dropped one basis point to 1.61%, having earlier risen to 1.67%, the highest since July 14.

Italian 10-year yields also dropped one basis point, to 2.09%.

Both Spain and Italy have their own political challenges that have implications for the EU bloc.

In the former, the Catalonia region has a disputed independence referendum scheduled for Oct 1 and while the result is unlikely to be accepted by Madrid, it could still create further divisions.

In Italy, the anti-euro Five Star Movement party is running close in polls to the ruling Democratic Party
ahead of elections next year.