LONDON (Reuters) - Italian and Spanish yields dipped back towards their lowest since 2005 on Tuesday as investors bet the European Central Bank will signal its readiness this week to take stimulus measures in coming months to fight potential deflation.
The ECB holds its policy meeting on Thursday and though many expect it to hold fire on interest rates, a fall in March euro zone inflation to 0.5 percent, its lowest since 2009, has kept alive prospects it will ease monetary policy later in the year.
Pressure for ECB action grew when the EU's top economic official, Olli Rehn, said prolonged low inflation would make it harder to correct imbalances in the region.
Peripheral euro zone bond yields have fallen to historical lows in recent days in anticipation of further policy easing from the ECB after a raft of dovish comments from policymakers, including the prospect quantitative easing.
Italian and Spanish 10-year yields were 1 basis point lower at 3.29 percent and 3.23 percent respectively, not far from last week levels - the lowest in more than 8 years.
"The market is not positioning for the ECB to do something this week ... But I'm sure they will keep a very dovish message whatever the decision they will take and this will keep the spread compression trades intact," BNP Paribas strategist Patrick Jacq said.
The ECB's ultra-easy policy stance and reduced concerns about the euro zone debt crisis helped peripheral euro zone bonds outperform lower-rated bonds in terms of total returns in the first quarter.
The trend is set to persist for months. Even if the ECB were to keep rates at record lows of 0.25 percent, top-rated bond yields would stay subdued at low levels, prompting investors to buy lower-rated debt as they try to maximize returns.
Even Greek bond yields, the highest in the euro zone, have fallen to their lowest in four years on the back of signs the junk-rated country might be over the worst of the recession.
The more buoyant market tone has even prompted Greek officials to flag a possible bond sale in coming months, its first since it was barred in 2010. Athens' return could mark one of the fastest comebacks of a defaulted sovereign.
On Tuesday, Slovenia, one of the region's smallest issuers, launched 3- and 7-year bonds. The offer drew combined order books of over 9 billion euros, a lead manager on the sale told IFR, a Thomson Reuters service. Slovenia has set a minimum size of 2 billion euros for the two bonds.
"We are still positive (on periphery debt markets); targeting ... a 5-year (Italian) BTP trading target of 1.50 percent yield and a medium-term 100 basis point BTP and Spanish 10-year spread target (over Bunds), though we expect Spain to get there sooner," RBS strategists said in a note. Italian 5-year bonds are yielding 1.93 percent.
Editing by Louise Ireland