By Ian Chua
LONDON, March 26 (Reuters) - Clouds hanging over higher-yielding euro zone government bonds look to be lifting as concerns subside over the risk of a break-up of the single currency area and as pressure mounts on the European Central Bank (ECB) to buy sovereign paper.
Both factors are seen contributing to what some analysts call a "normalisation" of these yields, which have recently soared to record highs against benchmark German Bunds.
"It's very hard for a government bond investor or a benchmark investor to remain short these markets at current spreads," said Gregor MacIntosh, investment director at Standard Life.
Peripheral euro zone government bonds such as Spanish and Greek government bonds have sharply underperformed benchmark German Bunds, seen as the region's safest and most liquid.
The premium investors demand to hold these bonds rocketed to record highs early this year when worries about weaker euro zone members mounted as the region battled severe economic headwinds.
Analyst research notes at the time expressed concerns that widening yield spreads were both flagging and compounding pressures that could risk sparking a break-up of the single currency zone.
Portugal, Greece and Spain saw their credit worthiness deteriorate and their credit ratings cut. To be sure, all 16 nations that make up the euro zone remain investment grade.
The 10-year Spanish bond yield rose to a record high of around 125 basis points over German paper just last month, while the equivalent Greek premium touched around 300 basis points.
These spreads were at roughly 25 and 50 basis points respectively before the credit crisis erupted in late 2007.
While the spreads are unlikely to return to pre-crisis levels any time soon, they are seen contracting further from extreme highs as these worries ease.
SOOTHING COMMENTS
Recent comments from ECB officials as well as European Union Economic and Monetary Affairs Commissioner Joaquin Almunia in support of the stability of the euro area have helped ease concerns about a split in the 16-nation bloc seen threatened by member economies slowing down at different rates.
ECB Governing Council member Axel Weber said this month that concerns about any euro zone member defaulting on its debt are unfounded and it would make no sense for any country to split from the area.
Weber also said while the "no bailout" clause in the European Union treaty was vital to prevent irresponsible behaviour, but in an extreme emergency, help could be provided.
Mounting pressure on the ECB to buy bonds to help lower term yields and boost the economy would be a further plus for peripheral bonds, analysts said.
The central banks of the United States, Japan, Britain and Switzerland have all launched programmes to purchase government and other paper as interest rates nearing zero force them to look to other steps to shore up slowing economies.
The ECB has room to cut rates further but is looking increasingly isolated among global monetary authorities as a result.
It has so far resisted the move to buy government bonds given that it faces a tougher time doing so, not least because it is barred from buying government debt in the primary market.
If it buys in the secondary market, it faces the question of how it selects the mix of national government bonds it buys from 16 member states.
Because the ECB cannot focus exclusively on Bunds when buying government bonds, euro zone government bonds with the highest premiums versus Bunds should benefit the most, said Peter Mueller, strategist at Commerzbank in Frankfurt.
Given the prospect of a fiscal backstop for the weaker euro zone members and the ECB buying government bonds, spreads should generally tighten across the the board initially, said Harvinder Sian, an analyst at RBS.
With unconventional monetary policy such as quantitative easing (QE) in focus as official interest rates near zero, central banks from the U.S. Federal Reserve to the Bank of England are pulling out all the stops to battle the worst global downturn since the Great Depression of the 1930s.
But the grim outlook for the euro zone means conventional policy measures may not be enough to restore growth and it's only a matter of time before the ECB followed suit.
"Europe is also suffering from the fact that QE in the U.S. and UK has resulted in currency depreciations versus euro. This effectively means that some of the required boost to growth in the U.S. and UK is being taken at Europe's expense," said Guy Skinner, investment director at SWIP.
"QE will boost Bunds but should help peripheral markets more since these have sold off aggressively as growth has slowed." (Editing by Jason Neely)