Markets: Canny Carlo has the edge on Flash Gordon

Investors who have kept faith with Italy's determination to hammer its economy into good enough shape to be in the first wave of countries joining a common currency in 1999 have made a ton of money, as a drop in the perceived risk of lending to the country has boosted the value of its bonds.

The gap between German and Italian 10-year yields - a measure of how much of a premium investors demand for investing in lire rather than German marks - fell to a record low last week.

Italy now pays about 6.5 per cent to borrow for 10 years - about one percentage point more than Germany pays, and half the premium investors were demanding four months ago. By comparison, the UK is paying about half a point more than Italy. Investors have more faith in Italy's Finance Minister Carlo Ciampi than in Gordon Brown. Interesting.

The profits to be made on Italian debt, however, have mostly been among longer-dated bonds. Italian two-year yields are still 2.65 points higher than those on German bonds, even though the gap has closed by 67 basis points in the past three months and is down from about 500 basis points 11 months ago.

That looks like the next big buying opportunity for euro-enthusiasts. "Short rates have to converge quite dramatically," says Dick Howard, senior strategist at Julius Baer Investments. "There is this anomaly between short- and long-dated bonds. We reckon that's where there's money to be made."

The expectation that yield gaps between short-dated Italian and German bonds will narrow, matching the performance seen in 10-year bonds, hinges on two beliefs: that EMU will occur, and that Italy will be included in the first round of the union.

Once the single currency is in place, the European central bank will have to create a reference money-market rate for all European countries involved in EMU. For that to happen, existing gaps between money-market rates have to disappear. Italian three-month money-market rates are now 6.82 per cent, more than double the 3.125 per cent rates seen in the German money market.

The prospect of further official interest-rate cuts in Italy later this year is good news for those betting that yields on Italian securities will fall closer to German levels. On 27 June the Bank of Italy cut official interest rates to 6.25 per cent from 6.75 per cent, its second rate cut this year.

US investment bank Lehman Brothers forecasts that the Bank of Italy will cut rates again in August. That's a good time for the central bank to act, Lehman reckons, because with many bankers and investors away on holiday, it will be easier to manage money-market liquidity. For investors, that makes short-dated Italian bonds worth buying ahead of the cut.

Julius Baer is also keen on buying shorter-dated securities, anticipating they will catch up with the convergence seen in longer-dated bonds. Mr Howard is forecasting that three-month Italian rates will fall to 4.5 per cent, and German rates will rise to 4.3 per cent, by the eve of EMU, almost erasing the current gap.

Forward yield analysis, which indicates where yields are expected to be in future based on current market values, points to a fall in the gap between two-year Italian and German yields. By January 1999 the gap is expected to shrink 102 basis points. Forward yields have proved a reliable guide to investor expectations about the prospects for monetary union.

For investors who expect markets to remain volatile in the run-up to the single currency's introduction, speculating on short-dated Italian securities can be balanced by simultaneously buying longer-dated bonds.

Michael Zelouf, director of international investments at Western Asset Management, is taking that route, because he thinks current market expectations for Italian rate cuts are unrealistic. "I wouldn't go near the short end without investing also in the long end," he said. "Two-year notes are the most expensive and they price in a fair amount of easing."

Zelouf's preferred trade is to buy 12-month or 18-month notes, buy 30- year bonds, and sell three-year notes. The trade is known as a barbell, because the investor ends up with a "heavy" bond position at either end of the maturity spectrum and a "light" position in the middle.

That strategy takes a more cautious approach than the one advised by Lehman to the speed and scale of expected Italian rate cuts. It is less risky, but it will also make less profit if yields on short-dated Italian securities do fall.

Even if Italy doesn't make the grade for EMU, Italian bonds are a buy as the government has been successful in whipping the economy into shape, said Stewart Cowley, head of fixed-income investments at Hill Samuel Asset Management.

"It's a no-brainer," said Mr Cowley, who has been investing heavily in long-dated Italian debt for the past two years, expecting the government to succeed in cutting its budget deficit, even if the 3 per cent EMU limit is missed.

Italy has halved its deficit from 6.7 per cent of gross domestic product in 1996. It plans to sell assets and trim welfare spending to get its budget deficit down to 3 per cent of gross domestic product by the end of this year.