UPDATE 1-ECB reinvestment plans lift Portuguese, Irish bonds

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By Dhara Ranasinghe and Abhinav Ramnarayan

LONDON, Dec 13 (Reuters) – Portuguese and Irish government bonds rallied sharply on Thursday, outperforming their euro zone peers after the European Central Bank said it would retain some flexibility in its bond reinvestment plans.

While the ECB formally announced the end of a three-year long quantitative easing scheme after its policy meeting and trimmed growth and inflation forecasts for the bloc, the bond market’s focus was firmly on its plans for reinvesting funds from maturing bonds next year.

As the ECB rebalances its 2 trillion euro ($2.27 trillion) government bond portfolio next year, Italy, France and Spain are likely to see demand for their debt wane.

Reuters calculations show that ECB holdings of Italian, Spanish and French government bonds would fall nearly 90 billion euros if the bank were to mirror its shareholder base.

ECB President Mario Draghi said it would not restrict itself to reinvesting in the countries where maturing bonds originated. That would favour Portugal and Ireland, analysts said.

“What the ECB is saying is that reinvestments don’t necessarily have to come back to the same country where purchases were originally made, because they want to address some of the under-buying before the new capital key,” said Marchel Alexandrovich, European financial economist at Jefferies.

Under the ECB capital key rule, bond purchases reflect the size of each euro zone member’s economy. The key was updated this month, with the shareholdings of Italy and Spain falling on account of their economies’ underperformance.

“What this practically means is that they will be buying countries such as Portugal and bit more Ireland, a bit more Cyprus, at the expense, potentially, of Italy and Spain because they hold more bonds than they should in these countries,” Alexandrovich added.

He said that in Portugal for instance, the ECB holds fewer bonds than it should under its rules and recognised that in coming years the government bond portfolio would need to be rebalanced to address the under-buying.

Portugal’s 10-year bond yield tumbled to a seven-month low of 1.673 percent and was down four basis points on the day by 1600 GMT.

Irish 10-year bond yields slipped 3 bps to 0.95 percent and Cypriot bond yields were 2 bps lower at 2.26 percent, outperforming most euro zone peers except Italy, where the market received a boost after Rome cut its 2019 budget deficit target.

With quantitative easing set to end, reinvestments are poised to become an important policy tool because ECB buying has subdued borrowing costs.

“The news for me is that they (the ECB) didn’t want to go longer in duration – many were waiting for some indications of operation twist,” said Natixis fixed income strategist Jean Christoph-Machedo, referring to the possibility that the ECB could skew purchases towards longer-dated maturities.

After the ECB trimmed its growth and inflation projections for next year and said downside economic risks were becoming more prominent, the euro dipped against major currencies and European stocks trimmed earlier gains .

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