Italian government bond yields fell from multi-year highs today, as a renewed attempt to form a government in Rome and a smooth bond auction brought a degree of calm to a market battered in recent days by political crisis.
The two anti-establishment parties, the 5-Star Movement and League, which had abandoned plans to jointly take power at the weekend after the president blocked their proposed cabinet lineup are now trying to find a compromise, a source said.
Italy's short-dated borrowing costs fell back below 2%, after surging more than 150 basis points on Tuesday as investors fretted about the prospect of fresh elections in Italy that could strengthen the hand of anti-establishment parties.
A sale of five and 10-year government bonds also eased concerns about Italy's ability to finance itself.
Italy sold €5.57 billion in bonds, narrowly missing the top of its targeted issuance range of €3.75-6 billion.
"Demand at today's auction was very encouraging, and clearly indicates that investors still have faith in the Italian economy, if not the government," said Seema Shah, global investment strategist at Principal Global Investors.
Italy's two-year government bond was last down 44 bps at 1.98%, having touched a 5-year high in early European trade.
Italian 10-year government bond yields fell 10 bps to 3.02%, off four-year highs of 3.38%.
The Italy/Germany 10-year bond yield spread tightened 13 bps to 266 bps compared to Tuesday's close of 283 bps.
"There's a bit of dip buying so I guess it's Italian investors buying, but we have to watch out for what other investors do as the day progresses, especially US investors," said DZ Bank strategist Daniel Lenz.
A political crisis has increased speculation around Italy's continued membership of the single currency and pushed its borrowing costs up sharply.
Some analysts said that they were sceptical of the possibility of Italy leaving the euro, a fear that contributed to the Italian 2-year yield recording its biggest one-day rise since 1992 on Tuesday.
"It's questionable how credible Italy's threat of leaving the EU actually is, if push comes to shove," said Barclays investment strategist Hao Ran Wee, citing blocks in the country's constitution as the main hurdle.
"No investor would lend to the Italian government if they deem it as being unable to pay back its debt," he said.
Yields on high-grade euro zone bonds, which have benefited from the turmoil in Italy, were 4-6 basis points higher and bounced off some of the lowest levels in months.
Germany's 10-year bond yields rose 8 bps to 0.36%, having hit a one-year low of 0.19% on Tuesday.
They also faced some upward pressure from inflation numbers.
Inflation in some German regions jumped above the ECB's target rate in May, pointing to robust consumer demand and feeding into a debate about when the European Central Bank should curb its monetary stimulus.