September 13, 2012 / 4:11 PM / 5 years ago

EURO GOVT-Bunds rise before Fed, Greece unsettles markets

* Bunds rise after sharp sell-off

* Markets wait for Fed QE decision

* Good demand at Italy's 6.5 bln euro bond sale

By Ana Nicolaci da Costa and Kirsten Donovan

LONDON, Sept 13 (Reuters) - German government bonds rose on Thursday as Greek concerns gave investors an excuse to pile back into safe-haven debt after sharp selling in the previous session and investors braced for more monetary support from the U.S. central bank.

The main focus was the U.S. Federal Reserve policy announcement due at 1630 GMT, with the central bank likely to launch a third round of bond purchases - dubbed QE3 - to try to breathe life into the sluggish economy.

"It will be a massive disappointment if they don't do anything, we're looking for QE3 and some extension of the zero interest rate policy," a trader said. "If we don't get that it's probably going to be another excuse for Bunds to sell off."

German Bund futures were up 74 ticks at a settlement close of 140.29 and outperformed their U.S. counterparts with the yield spread between U.S. and German 10-year paper widening 5 basis points to around 17 bps.

The Bund hit a session high of 140.47 after a report citing Greece's representative to the International Monetary Fund saying Athens would need a third bailout package.

Even though the report was denied by the country's finance minister, the price moves highlighted markets extreme sensitivity about Greece's future in the euro.

Gianluca Salford, European fixed income strategist at JP Morgan, said he was bullish on German Bunds:

"Clearly there is massive pressure for yield pick-up, rotating portfolios into a more aggressive position. However, we recently got headlines on Greece and there is still work that needs to be done on Spain, so we haven't really embraced the risk-on trade," Salford added.

PRECARIOUS PERIPHERALS

Investor appetite for riskier assets got a big boost on Wednesday when Germany's Constitutional Court cleared the way for the European Central Bank to buy bonds of struggling euro zone countries - a major plank in policymakers' plans to curb the region's debt crisis.

That spurred demand at an Italian bond sale, allowing the country to sell 6.5 billion euros of bonds, including 2026 paper - the longest-maturity conventional bond Italy has tried to sell in more than a year.

"They are very solid figures. The issues were slightly expensive versus the secondary market and the volumes look very strong ... 1.5 billion euros of the 2026 paper. That was the one to watch given the long maturity," said Michael Leister, rate strategist at Commerzbank.

"There is decent demand out there for risk and peripheral paper and obviously yesterday's German court ruling and last week's ECB announcement have underpinned this move."

In the secondary market, Italian 10-year bond yields were down 1 basis point at 5.02 percent, while Spanish yields were flat at 5.66 percent.

Ireland also sold T-bills on Thursday, as it paved the way to make a full return to bond markets, paying the same to borrow for three months as Italy did the previous day.

Key for both Spain and Italy in the longer term will be whether they can draw back some of the international investors who have dumped their bonds this year.

Traders said demand for the paper, although picking up, still came overwhelmingly from domestic investors, although one said he had seen some switching from equities and corporate bonds - which have rallied since June - into peripheral bonds.

Although viewing the ECB plan as positive for markets, Jack Kelly, a fund manager at Standard Life, which has $247 billion under management, said that alone was probably not enough.

"To get long we really need to see the nature of the ECB buying and their reluctance, or not, and what the scale of the buying is. It may be longer than the market thinks before the Spanish actually request aid," Kelly said.

"We think peripheral spreads are likely to stabilise around these levels and the volatility may drop, but we don't see much outperformance from here as we've already had such a big move."

Analysts also say the threat of further credit rating cuts - Spain is already on the brink of "junk" status - will deter investors and economic growth will be necessary to entice buyers back.

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