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UPDATE 2-Bond markets lurch between economic optimism and ECB caution
May 24, 2017 / 10:32 AM / 3 months ago

UPDATE 2-Bond markets lurch between economic optimism and ECB caution

* Best run for euro zone economy in a decade

* But policymakers warn about withdrawing stimulus

* Bloc's bond yields reverse early rise

* Germany auctions 10-year bonds (Adds Draghi comments, updates prices for close)

By John Geddie

LONDON, May 24 (Reuters) - The cautious tone of euro zone central bankers in the wake of some of the best economic data in years sent mixed signals to investors in the bloc's debt markets on Wednesday.

Government bond yields across the region have been pegged near record lows in recent years as the European Central Bank has spent trillions of euros on an asset purchase scheme and cut interest rates deep into negative territory.

But with the bloc's economy on its best run in a decade - exemplified by a survey showing German consumers at their most optimistic in nearly 16 years - and the ECB's purchase scheme set to expire in December, investors are becoming increasingly uncertain how long the central bank can hold its ground.

Key policymakers on Wednesday reiterated the dangers of withdrawing its ultra-easy policy too early, with a report warning that the risk of a sudden repricing of bond markets remained significant.

Europe's benchmark German 10-year bond yield rose some 2 basis points in early trading to 0.42 percent after the German GfK data, but after the ECB comments were back down at around 0.40 percent and little changed on the day.

Most other euro zone yields were little changed to a touch higher.

"The more we see upside surprises on growth, the more the ECB could justify removing some of the stimulus slightly earlier," said Mizuho's head of euro rates strategy Peter Chatwell.

Wednesday's consumer sentiment survey is just the latest in a run of improving data with an economic indicator on Tuesday showing that euro zone business growth remains at its strongest since 2011.

About three quarters of economists in a Reuters poll said the ECB will signal it is winding down its monthly asset purchases by September, with six of those expecting the central bank to move as early as next month.

But inflation remains the elephant in the room for the ECB.

While it has jumped into the ECB's near two percent target range in recent months, chief economist Peter Praet said on Wednesday that the central bank needs to see more evidence of a sustained pick-up before it can reduce its stimulus.

ECB Vice President Vitor Constancio said the central bank must err on the side of removing stimulus too late rather than too early.

Markets are pricing in more than a 50 percent chance that the ECB will raise interest rates in March 2018.

But ECB executive board member Benoit Coeure said on Tuesday that negative interest rates have been an effective monetary policy tool and there was no reason to change its guidance on their use.

While ECB policymakers mull over their next steps to be unveiled at a meeting in Tallinn, Estonia on June 8, minutes of the U.S. Federal Reserve's last meeting will be released at 1800 GMT.

Analysts say they are unlikely to erode high expectations for a June rate increase in the U.S.

Elsewhere at the auctions, there was solid demand for 2.45 billion euros of 10-year bonds sold by Germany.

For Reuters Live Markets blog on European and UK stock markets, see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets (Editing by Raissa Kasolowsky and John Stonestreet)

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