INVESTMENT FOCUS-Splintering euro zone debt market down to Draghi, not politics

Big bond funds are becoming increasingly reluctant to lend to the euro zone's weakest members, looking past a crowded electoral calendar to an eventual winding down of the European Central Bank's ultra-loose monetary policy.

In recent months, the funds have been hiking the premiums they demand to buy bonds from highly-indebted southern European states such as Portugal and Italy.

Many analysts have put much of that to fears that the anti-establishment wave behind Brexit and Donald Trump's U.S. presidential election win could sweep anti-establishment parties to power in a series of European elections this year.

But the first of those votes in the Netherlands last week threw into sharp relief that for many investors there are more risks facing the bloc's weakest debt markets than just politics.

There was little change in relative borrowing costs after Prime Minister Mark Rutte fended off a challenge from the far-right populist Geert Wilders in the Dutch election.

Top of the risks list is whether the European Central Bank will soon withdraw the life support that has kept many of the weaker economies functioning and compressed government bond yields.

"The better the political outcome in all of these European elections, the more flexibility the ECB has to one day withdraw the stimulus," said Michael Krautzberger, the head of European fixed income at the world's biggest asset manager, BlackRock.

"I would expect that we have much more country differentiation in a scenario where the ECB finally withdraws from the market because that uniform factor falls away."

At the start of April, the ECB will scale back the billions of euros its spends each month on a bond-buying scheme designed to prop up growth and inflation.

That may be just the start. At its March meeting, ECB President Mario Draghi said its sense of urgency was over. Investors have begun to anticipate interest rate rises by the end of this year.

"DRUGS DON'T WORK"

Some analysts warn that if the ECB tries to wind down its programme quickly, borrowing costs for so-called peripheral countries relative to Germany -- known as the spread -- could widen by as much as 1-2 percentage points.

For the likes of Portugal that would put borrowing costs back towards levels seen as unsustainable for managing debts.

In a similar way that some emerging countries suffered in the backdraft of U.S. hints it would scale back monetary easing in 2013, the bloc's weakest links may be punished by markets.

"The drugs don't work already and when you take steps towards pricing in less drugs – QE – then you price in spread widening," said Richard McGuire, head of rates strategy at Rabobank.

Spain and Italy have been among the poorest performing bond markets in the euro area this year. http://reut.rs/2mYpNZU

The German/Italian 10-year yield gap this week rose above 200 basis points to its widest in three years.

There was little change in these spreads last week's Dutch election. Investors say French bonds could win some respite if the eurosceptic Marine Le Pen is defeated in May's presidential vote.

But it is unclear whether the same is true for the debt of Italy and Portugal, where governments have struggled to implement structural reforms and shore up a fragile banking sector.

"As the ECB gradually withdraws monetary stimulus this year and next, that will place a disproportionate challenge on the weaker countries to grow under the tighter monetary stance," said Andrew Bosomworth, head of portfolio management in Germany at PIMCO, one of the world's largest bond investors.

"Hence we see valuations in peripheral countries as vulnerable, especially if they do not or cannot compensate for less monetary stimulus with stimulative fiscal policy or growth-enhancing structural reforms."

Election uncertainty in the euro zone has also been weighing down market inflation expectations in the bloc.

Analysts say those expectations should snap back once the political hurdles are cleared, meeting the ECB's near 2 percent target and supporting the case for tighter policy.

For the currency market, some argue the prospect of tighter policy is set to prove as least as important as politics over the next six months.

Bets against the euro hit their lowest in nearly a year after this month's ECB's meeting and major banks have abandoned predictions for a fall to parity with the dollar.

"Politics is always only part of the equation and ECB policy is certainly as important, if not more important, for euro zone bond markets," Valentijn van Nieuwenhuijzen, chief investment strategist with Dutch financial group NNIP said.

"If the underlying backdrop in terms of growth, earnings, inflation is actually surprising to the upside. Politics are a sideshow rather than a driver of markets."

(This article has not been edited by DNA's editorial team and is auto-generated from an agency feed.)