MILAN (Reuters) - A rally that has pushed Italy's long-term borrowing costs to their lowest since late 2010 is seen continuing if the newly-designated prime minister can form a government and revive the reform agenda put on hold at the end of 2012.
Italian President Giorgio Napolitano on Wednesday asked centre-left deputy leader Enrico Letta to form a new executive, signalling the end of a damaging vacuum since elections in the euro zone's third largest economy in February.
The new government will be backed primarily by Letta's centre-left and the centre-right of Silvio Berlusconi, which had hitherto repeatedly failed to cut a deal after the vote.
"Unlike the previous attempt at the end of March, we think this process should be relatively smooth and could be concluded as soon as the end of next week," said Francesco Garzarelli, head of market research for Europe at Goldman Sachs.
Foreign investors, who feared potentially destabilising snap elections after an inconclusive February vote, are now turning with renewed attention to Italy and its ability to reform an economy stuck in a painful recession since the summer of 2011.
The positive developments in Italy come in a very favourable market environment as expectations that central banks around the world will continue to support growth have triggered a desperate hunt for returns.
"Accommodative monetary policies from the U.S. Federal Reserve and the Bank of Japan to the European Central Bank are creating a huge downward pressure on bond yields," said Riccardo Barbieri, chief economist for Europe at Mizuho international.
"This is why investors are lining up to buy peripheral bonds," Barbieri said.
On Tuesday the expectation that a new government would be formed pushed Italy's 10-year funding costs to 3.89 percent, below the psychologically important threshold of 4 percent for the first time since November 2010.
This compares with Japanese government bond yields below 1 percent and with rates on 10-year U.S. Treasuries of around 1.70 percent. In the euro zone the equivalent German bond is offering investors a rate of around 1.30 percent.
BACK ON TRACK
After some profit-taking, analysts said the market could extend the rally in Italian debt, should the new Italian government win investors confidence.
"The new administration will have to show the reform agenda is back on track," said Jean-Francois Robin, strategist at Natixis.
"The reform of the electoral law is just one step, investors need to see some measure to help growth and to get more flexibility in the Italian economy," he said.
Barbieri at Mizuho believes Japanese investors, who hold significant investment firepower, could return to Italy if the outlook for the next one to two years becomes more predictable.
He put a target of 3.50 percent for Italy's 10-year bond yield in the coming months, if the new government is able to deliver on reforms.
This would be even less than half of the borrowing costs Rome paid to sell 10-year bonds in autumn 2011, when Italy was at the centre of the euro zone sovereign debt crisis.
Other analysts are more cautious and look at a goal of around 3.70 percent, last seen in October 2010.
The premium Italian debt pays over safer German bonds would tighten in parallel to the 250-basis-point level.
The country's problems are not over, with significant differences remaining between left and right over economic policy.
But for some, Italian bonds stand out amongst those euro zone states on the front line of the debt crisis.
"(Italy has) made many structural changes, they're on the right track despite the recent hiccup over the formation of the government. And I don't think that's important longer term - they've had many periods without governments," said David Zahn, newly-appointed Head of European Fixed Income at U.S. asset manager Franklin Templeton Investments - which has $823 billion in assets under management.
"We like Italy. They've done good things and you get paid for that," he said.
"Spain? Not so much, we prefer Italy more than Spain."
(Editing by Toby Chopra)
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