July 2, 2018 / 11:03 AM / a year ago

UPDATE 2-German bond yields hover near five-week lows as Merkel

* Trade war fears lift demand for bond safe havens

* German two-to-10-year yield gap tightest in a year

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds report on German coalition meeting, updates prices)

By Dhara Ranasinghe

LONDON, July 2 (Reuters) - German 10-year bond yields dipped to five-week lows on Monday, pushed down by political uncertainty in Germany, trade war fears and an expectation that the ECB could buy more long-dated bonds from next year to keep euro zone borrowing costs in check.

Analysts put the move down to a combination of factors, starting with political uncertainty at home.

Merkel is trying to solve a migration row with her conservative allies by holding more talks with her interior minister, whose offer to resign has cast doubt over whether her fragile government can survive.

Escalating trade tensions globally also boosted demand for bond market safe havens.

Chinese shares notched up falls of up to 3 percent as firms awaited $34 billion of U.S. tariffs on Chinese goods this week and as new business surveys showed some worrying signs of deterioration.

“Euro area yields are extremely compressed at the moment and what the market is trading off is tail risk,” said Peter Chatwell, head of rates strategy at Mizuho in London. “The real momentum is because of trade wars and the impact on the economy and most significantly on the U.S. economy.”

The yield on Germany’s 10-year Bund fell 2 basis points to 0.284 percent, its lowest level in almost five weeks and towards more than one-year lows hit at the peak of a selloff in Italian bonds in late May.

Later in the session there were reports that German Chancellor Angela Merkel was to meet with leaders of the other parties that make up the coalition government on Monday. The German 10-year yield was set to close at 0.31 percent.

The gap between two and 10-year government bond yields in Germany, the euro zone’s biggest economy and its benchmark debt issuer, narrowed to its tightest in a year at around 98 bps.

“We are in an environment driven by increased uncertainty, whether that’s trade wars or European politics or Italy,” said Christian Lenk, a rates strategist at DZ Bank. “That adds to the picture that investors are happy to own safer assets over the summer months.”

Most other 10-year euro zone bond yields were flat on the day, though Southern European bond yields edged lower by 3-4 bps towards the end of the session.

But the mood was still fragile - European stocks, for instance, were down 0.6 percent on the day.

On Friday, Reuters reported that the European Central Bank is considering buying more long-dated bonds from next year to keep euro zone borrowing costs in check even after it stops pumping fresh money into the economy, according to sources.

The move would be reminiscent of the U.S. Federal Reserve’s Operation Twist of 1961 and 2011, which saw it replace short-dated paper with longer-term debt to support an ailing economy.

Analysts said the ECB report helped support long-dated German bonds, although any further flattening in the German yield curve was likely to be limited.

Reporting by Dhara Ranasinghe Editing by Catherine Evans

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