By Joe Wallace
Investors welcomed signs of progress in the European Union's negotiations over a landmark economic recovery plan Monday, pushing down government borrowing costs and boosting the euro to a four-month high.
European Union leaders were inching closer to agreement on a likely EUR1.8 trillion ($2.06 trillion) coronavirus recovery package, comprising a multiyear budget and a recovery fund. Investors are increasingly hopeful that the talks, which diplomats said could stretch on into the evening, will result in a deal.
In one sign of optimism, the gap between the yields on Italian and German government bonds shrank to its lowest level since late March. Investors demanded an additional 1.59 percentage points to hold 10-year Italian bonds instead of the equivalent German debt, according to Tradeweb, the lowest closing level for the closely watched spread since March 26.
The recovery fund is intended to prop up economies worst-hit by the pandemic, including Italy and Greece, by allowing them to spend money without lifting borrowing costs. To fund it, the European Commission would raise hundreds of billions of euros of common debt in the markets, an unprecedented step that investors say could help secure the eurozone's long-term survival.
"The fact the council meeting is grinding its way into a fourth day is, I think, being taken as a signal that by the time we come in tomorrow morning, there will be a deal on the table," said Adrian Hilton, head of global rates and currencies at Columbia Threadneedle Investments. "Up to now, the EU has been hamstrung in that the borrowing capacity of the EU has been extremely limited."
Although most of the EU has monetary policy set by the European Central Bank, fiscal policy is largely conducted by individual member states. The EU is only allowed to borrow to finance loans to countries under specific programs. It has about EUR52 billion in outstanding debt instruments, according to the European Commission.
The recovery fund would change that, allowing the bloc to raise debt on a much larger scale and distribute the proceeds to regions and nations where they are most needed. This could help solve a long-running problem for European investors, who don't have a regional equivalent of U.S. Treasurys: A shortage of assets considered to be safe has pushed yields on German debt ever further below zero.
Common EU bonds would yield roughly the same as French government debt, or around minus 0.16% for a 10-year bond, said Iain Stealey, international chief investment officer for fixed income at J.P. Morgan Asset Management. He said his firm would consider buying the bonds in some of its more defensive funds, swapping them for German bunds, which yield around minus 0.5%.
In another sign of investor optimism, the euro briefly rose to just under $1.15, its highest rate since early March, before shedding those gains. The shared currency has strengthened over the past two months after sinking when companies and investors rushed for the safety of the dollar in March. The spreads on Spanish, Greek and Portuguese sovereign debt also tightened, suggesting investors' appetite for riskier debt increased.
"It's a statement of intent at a very important time and it diminishes the breakup risk for the euro," said James McCormick, global head of desk strategy at NatWest Markets. "This is 27 leaders from 27 different countries with different levels of balance-sheet health, different approaches to fiscal policy, unanimously agreeing to mutualize a very large liability caused by this crisis."
Leaders came close to consensus on the key ingredient in the recovery plan Monday morning. They honed in on a figure of EUR390 billion for the grants Brussels will hand out, mainly to member states.
Some investors said that the recovery fund, though welcome, would take time to feed into stronger economic growth and wouldn't address longer-running problems in the eurozone. The chances of an anti-EU government coming to power in Italy remain high and will curtail investors' appetite for Italian debt, said Andrew Mulliner, a fund manager at Janus Henderson Investors.
"The internal political problems of Italy are there and will come back," said Mr. Mulliner. "For the time being, Italy looks like a pretty attractive yield, but there's a limit to how far we can tighten," he added, referring to the spread between German and Italian yields.
In the U.S. bond market, the yield on the 10-year Treasury note held steady at 0.628%.
Write to Joe Wallace at Joe.Wallace@wsj.com