Risks besieging Europe bonds to spill over into 2019

London

FOR the European bond investors who survived a bruising 2018, there may be bad news in the year ahead.

Higher government spending and political uncertainty threaten rising debt yields in Italy and France, which could spill over elsewhere. Markets don't expect the European Central Bank to raise interest rates given slowing growth and trade risks, making a sell-off in Germany's haven bunds look unlikely. "The ECB's exit plan will be put to the test, at a time when the Fed is done after the US curve inverts, Britain barely averts a hard Brexit and investors fret how Italy can cope in the monetary union," wrote Commerzbank AG strategist Christoph Rieger. "Under most scenarios, bund yields cannot rise."

Here's a preview of what to expect from euro-area bonds this year:

Germany

2018 10-year yield finish: 0.24 per cent

2019 10-year yield forecast: 0.89 per cent

Last year: Bunds got caught up in a global sell-off in the early part of 2018 as investors were spooked by rising inflation, but that proved short-lived.

Key risks: German bonds have been supported by a swathe of risk factors in recent months, ranging from global trade war fears to Italy's budget battles. Any signs of those fading, or better-than-expected data in the region, or the UK securing a smooth divorce from the European Union could presage higher yields.

What analysts say: "We suggest a long bias initially, looking to reduce duration during spring with a view to lengthen duration again after summer when US yields look set to peak and the ECB delays the first rate hike into next year," Commerzbank's Mr Rieger says.

Italy

2018 10-year yield finish: 2.74 per cent

2019 10-year yield forecast: 3.37 per cent

Last year: It was one to forget for Italian bond investors, with the securities the worst performing in the euro area.

Key risks: Italy may have avoided the EU's excessive deficit procedure for now, but the threat of recession means it has not gone away entirely. Investors will also be looking for any further signs of strain from within the governing coalition over their diverging spending plans and the growing popularity of the League and its leader Matteo Salvini. A breakdown could see fresh elections in 2019.

What analysts say: "BTP spreads at 400 basis points or more will likely cause significant stresses in the Italian banking system, and either break the current Five Star Movement-League coalition or cause a course reversal," wrote Goldman Sachs strategists led by Praveen Korapaty.

France

2018 10-year yield finish: 0.71 per cent

2019 10-year yield forecast: 1.2 per cent

Last year: French bond yields finished the year more-or-less where they started.

Key risks: Alongside heavy borrowing this year, investors will likely pay close attention to Emmanuel Macron's approval rating, which dropped for a fifth straight month in December and currently languishes at 31 per cent, according to a recent poll.

What analysts say: Bank of America Merrill Lynch recommends investors position for a flatter French yield curve, which has the "the added 'benefit' of higher re-denomination risk pricing in the front-end", wrote strategists Erjon Satko and Sphia Salim in a note to clients. "This last element would gain importance if demonstrations in France continue, potentially destabilising Macron's position ahead of the European elections." BLOOMBERG