By Yoruk Bahceli and Olga Cotaga
LONDON (Reuters) - A Franco-German proposal for a half-a-trillion euro recovery fund has lifted Italian bonds and the common currency, but investors say the effect may wear off soon once sceptical Northern European countries get their say.
Bond investors have long hoped for some form of joint financing to tackle the costs of fighting the coronavirus pandemic, which has hit heavily indebted Italy particularly hard.
Italian bonds rallied and the closely watched risk premium Italy pays on its debt fell to its lowest in over a month at 208 bps
But investors are expecting more market volatility ahead until an agreement is reached, given the rift between the fiscally hawkish northern EU countries and the southern members looking for liability sharing.
A group of European Union states opposed to big spending by the bloc will present a counter-proposal to the Franco-German one, Austrian Chancellor Sebastian Kurz said on Tuesday.
"There are a lot of hurdles they need to get over before any cash gets distributed to those peripheral (states) that really need them," said Nick Sanders, a portfolio manager at AllianceBernstein (NYSE:AB), who said he took some profits from his overweight position on Italian bonds following Monday's rally.
"Markets reacted rightly strongly yesterday but I think we will see additional negative headlines...and volatility."
The package is highly likely to be watered down to appease the hawkish states, Rabobank analysts told clients, warning that this could potentially lead to a portion of the recovery fund being provided in the form of loans, rather than grants.
In a recent fund manager survey by BofA, investors saw the potential break-up of the euro area as the third biggest risk for financial markets after a second wave of coronavirus infections and permanent unemployment.
In the short-term, the most crucial factor driving Southern European borrowing costs will remain the European Central Bank's emergency bond purchases, investors told Reuters.
Markets expect that the bank will scale up purchases at its meeting on June 4, so a failure to do so could push Italy's borrowing costs back up again.
"Whether it likes it or not, the ECB will be the principal setter of bond prices in European fixed income for the foreseeable future," said Mark Dowding, chief investment officer at Bluebay Asset Management.
(GRAPHIC - Italian debt risk premium: https://fingfx.thomsonreuters.com/gfx/buzz/qmyvmneqkpr/italian%20spread%2019%20may.png)
The announcement of the recovery fund to help its shakier members also helped prop up the euro itself. The currency (EUR=EBS) jumped to a two-week high, but settled at $1.0927 against the dollar -- still well below the $1.14 levels it hit in early March.
"Today may mark the start of the EU truly having its own federal identity. But...it is difficult to envisage that a rally in the euro be sustained in the short term based on this alone," said Jordan Rochester, currency strategist at Nomura, who remained short the euro.
A further rally in euro was curtailed by positioning, with the latest CFTC data showing speculative funds were already long the common currency, last holding $10.6 billion in positions close to two-year highs, making it harder for the currency to jump on positive news.
On top of that, the derivatives market implies bets on the euro still skew bearish. The premium for euro puts -- options conferring the right to sell the euro -- has shrunk but remains higher than that for calls, which would allow holders to buy.
More importantly, about $1.5 billion in euro/dollar options expiring on Friday had a strike of $1.13, making some traders inclined to keep the euro below this level.
(GRAPHIC - Traders hold big chunk of euro options at 1.13: https://fingfx.thomsonreuters.com/gfx/mkt/azgpomgjxpd/Traders%20hold%20big%20chunk%20of%20euro%20options%20at%201.13.PNG)
After a knee-jerk reaction, the euro gave up most of Tuesday's gains but still stayed at two-week highs.
"Reserve your judgement is what I should say. I want to see this done and I want to see more detail," said Kenneth Broux, head of corporate research at Societe Generale (OTC:SCGLY).
European countries "need the money now, they need it ASAP (as soon as possible)."