Fiscal uncertainty in Spain and a cut in Italy's ratings outlook pushed Bund prices to 5-month highs

Fiscal uncertainty in Spain and a cut in Italy's ratings outlook pushed Bund prices to 5-month highs and held Spain's 10-year yields close to recent peaks on Monday, with room to rise further if a T-bill sale struggles.

Standard & Poor's cut its outlook for Italy to "negative" from "stable" on Saturday, while a crushing defeat for Spain's ruling socialists in local elections raised worries about Prime Minister Jose Luiz Rodrigo Zapatero's ability to meet fiscal targets. [ID:nLDE74M0V7]

The news on two of the euro zone's fundamentally stronger fringe countries came on the back of increasing talk about a Greek debt restructuring, heightening contagion concerns.

The yield spreads between Italian and Spanish 10-year paper over benchmark German Bunds hit their widest since January at 186 basis points and 261 bps respectively, before easing slightly.

Spanish 10-year yields were 3.3 basis points higher on the day, at 5.523 percent, staying close to the upper end of this year's 5.1-5.6 percent range. A break above the range could occur in the next few days, especially if Tuesday's sale of up to 2.5 billion euros in 3- and 6-month bills disappoints.

"It is quite close to the upper end of the range and that makes it quite appealing but the risk that we get pushed out of this range is also high ... so we are rather recommending a cautious stance ... on Spanish and Italian (government bonds)," said David Schnautz, interest rate strategist at Commerzbank.

He said the auctions could be watched more closely for this reason, although he did not expect significant problems.

The main risk, he said, was that real money investors -- which typically take more time before deciding on a new position -- could trim or even close their exposure on Spain.

"The market will pay close attention to any rebalancing of real money accounts after the weekend," Schnautz said.

"Portfolio relocations could be an underlying theme of the coming days. If there's any sign of real money selling or not buying, that will be the crucial point."

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