From outcast to star: euro periphery rally gains pace

By Stefano Rebaudo, Yoruk Bahceli and Dhara Ranasinghe

LONDON (Reuters) -The premium investors demand to hold Greek bonds over Germany has fallen to its lowest since 2008, and Italy's isn't far off levels seen in 2010, a sign of improved fiscal dynamics in a region once at the heart of the euro debt crisis.

Generally stronger economic growth and an emerging Make Europe Great Again theme are boosting peripheral markets.

"The outlook for Southern Europe seems more rosy than we see within core Europe, and it has some nice, attractive yield properties," said Royal London Asset Management (RLAM) fund manager Gareth Hill.

Here's a look at how that's playing out:

1/ NOT SO WEAK LINK

Political stability and a debt reduction path viewed as credible by investors allowed Italian spreads to benefit from the rise of risk assets and European Central Bank easing since late 2023.

U.S. policy uncertainty under President Donald Trump is also seen as a catalyst for even more euro area joint funding for defence spending, taking pressure off indebted Italy, while potential foreign flows seek a new home in Europe.

"One trade I like right now is to be long Italy, not against Germany, but just outright, because the Bund (price) could start rallying again," said UBS rate strategist Reinout De Bock.

Italy's bond yield gap over Germany is below 100 basis points (bps). Its spread over France is just 25 bps, versus over 200 bps in 2022.

Benjamin Moulle, global head of primary credit for sovereigns, supranationals and agencies at Credit Agricole CIB, said he was seeing more clients putting in orders for Italian bond sales and placing larger tickets for them, with "a lot of trust belief in the current Italian economic and political stability."

2/ CLUB MED

While Italy's bond spread has seen the biggest drop this year, sentiment across the Mediterranean is firm.

The premium that once-bailed-out Greece pays over Germany dropped to the lowest since 2008 in June, underscoring how the euro debt crisis is now distant history for investors.

Greek bonds now yield roughly the same as the second-largest euro zone economy, France, which has been hurt by political instability and fiscal worries.

A Moody's ratings upgrade in March, putting Greece firmly back in investment-grade territory, is testament to the turnaround.

The real standout, however, is Spain, which grew 3.2% last year, more than triple the euro zone's 0.9% expansion and in contrast to Germany's 0.2% contraction.

That's comforting bondholders as strong growth aids debt sustainability.

"What we have seen is structural compression of spreads... that's become a structural feature," Carla Diaz Alvarez de Toledo, director general, treasury and financial policy at Spain's economy ministry, told the Financial Times Global Borrowers and Bond Investors Forum on Tuesday.

3/ PURSE STRINGS

While the EU expects Germany's budget deficit to hover just under 3% as a share of output, which is the bloc's limit, it expects Italy's to drop to 2.9% by end-2026, from 7.2% last year.

Spain's deficit is forecast to drop to 2.5% from 3.2%.

That's being driven by a lack of urgency to spend on defense, due in part to fiscal constraints in southern Europe.

Neither Italy, nor Spain - unlike Germany -- have applied for the EU's "escape clause" to avoid disciplinary steps if defense spending raises deficits above 3%. Still, Italy has called for a further deficit leeway to allow for increased defence spending.

The periphery should also benefit from up to 150 billion euros of loans for joint defense projects the EU will fund with joint borrowing.

"There's less pressure for them to increase their debt issuance," said RLAM's Hill, who favours Spanish bonds.

4/ NOT JUST BONDS

Improved confidence in Europe's outlook has also boosted stocks, with Italy and Spain up 15% and 20% respectively year-to-date. The broad STOXX 600 has gained almost 7%.

The post-COVID EU recovery fund has benefited Southern Europe the most, while plans for increased fiscal stimulus in laggard Germany are expected to boost the euro area as a whole.

"European equities offer distinct, compelling plays," said Jacob Falkencrone, global head of investment strategy at Saxo.

"Spain: Strong near-term economic momentum. Germany: Powerful structural catalysts with long-term upside. France: Short-term headwinds, but strategically positioned to benefit from broader European strength."

5/ WHAT BREAK-UP RISK?

Euro area break-up risks, which flared during the Covid crisis in 2020, have died out.

Look at credit default swaps, essentially insurance against default risk and one way of gauging investor perceptions of euro area risks. Five-year Italian CDS are at their lowest since at least 2010. Greek, Spanish and Portuguese CDS all point lower.

Still, analysts caveat that while euro area break-up risks are no longer on investors' radar, France remains a concern, while political risk has also resurfaced in Spain in recent days.

(Reporting by Stefano Rebaudo in Milan and Yoruk Bahceli and Dhara Ranasinghe in London; Editing by Bernadette Baum)