During 2013 Spanish and Italian bonds have had a strong rally, with yields falling to long-term lows. If one looks at MFI balance sheet data from the ECB, the conclusion is that the fall in prices can be attributed to domestic banks using deposit inflows in order to buy government bonds.

Spain

Spain MFI Balance Sheet Items - Flows - 201206 - 201303

The Spanish data show that domestic banks were strong net buyers of government securities through out 2013, with a total of €28.7bn in purchases. These were financed by increased deposits due to inflows by retail customers. Spanish banks do not appear to have been successful in accessing the money and capital markets with both deposits to MFIs and Debt Securities issued flows being negative.

Italy

Italy MFI Balance Sheet Items - Flows - 201206 - 201303

The Italian data are quite similar, with banks increasing their holdings of government securities even more than Spanish banks (a total of €34.1bn during 2013). Domestic credit institutions had a very strong inflow of funds during February and March (almost €60bn), mostly from retail deposits but also from money markets (at least during February). Capital market flows (debt securities) were negative almost €30bn.

Conclusions

Given the ongoing recession in both Italy and Spain and the increasing share of NPLs, domestic banks seem to have adopted a policy of investing any deposit inflows on government securities in a search of yield and relative principal protection (although taking a duration risk). Foreign investors seem to be increasing their positions at a steady pace or at least maintaining them (data on holders for Spain and Italy). As long as deposits keep returning to Spain and Italy and foreign investors are calm the above policy seems to be wining and providing significant capital gains.