French debt yields ease

Pressure on French government bonds eased on Wednesday after the European Central Bank stepped in to calm the market, but its intervention was not aggressive enough to assuage fears the debt crisis was spreading to the euro zone's second biggest economy.

The yield premium of the French 10-year government bond over German Bunds rose as high as high as 192 basis points before easing back to 182 bps, slightly tighter on the day, as Italian and Spanish debt yields fell.

France has overtaken Italy as the latest target of investor angst as a comprehensive solution to draw a line under the region's two-year debt problems remains elusive, with contagion spreading to other top-rated sovereign issuers such as Holland and Austria.

The ECB's forays in the secondary market have so far failed to stem contagion. Market pressure is growing on the central bank to buy large amounts of bonds without sterilising the purchases - effectively the same process of pumping cash into the market undertaken by the US and UK central banks.

“It's difficult to see a fundamental game changer for the time being,” Rainer Guntermann, a strategist at Commerzbank, said.

“The pressure is on the ECB. There are more calls on the ECB to step in more broadly to be a lender of last resort. It is not yet prepared to do these things. That's why the market will remain fragile,” he said.

The cost of insuring French debt against default fell, along with that of Spain and Italy, with expectations that the appointment of a new government in Italy would bring some short-term relief to the market.

Italian 10-year government bond yields were down around 28 basis points on the day at 6.95 percent, after rising sharply to above 7 percent in the previous session. The two-year Italian yield slumped 50 basis points to 6.21 percent.

Although ECB buying was bringing down the yields, ever widening spread between what bid/offer spreads reflected the market's dwindling liquidity. For 10-year bonds this is now at 150 cents, compared with around 130 bps on Tuesday.

“Given the magnitude of the recent moves and with signs that France and Dutch issues are now being affected, the possibility of more radical intervention becomes much greater,” Barclays Capital strategists said in a note.

Guntermann and some traders said most investors were using any bounce in peripheral euro zone bond prices, other than German Bunds, to cut their exposure to the lower-rated debt in the absence of fresh measures to resolve the crisis.

“Spreads will continue to widen even from these levels until we get some sort of bazooka-type response which there are no signs of at this point in time,” a trader said.

“Trading is very difficult. Liquidity is very poor ... Bunds are OK but for every other market bid/offers are incredibly wide and therefore adding to the volatility and I can't see that getting any better.” - Reuters