January 24, 2018 / 8:25 AM / a year ago

Euro zone bond markets turn defensive as ECB meeting looms

* Euro hits 3-year highs vs dollar

* Lifts expectation of dovish ECB meeting Thursday

* Stellar periphery rally

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr

By Dhara Ranasinghe

LONDON, Jan 24 (Reuters) - Bond yields in the euro area crept up on Wednesday, as a note of caution settled into fixed income markets a day ahead of a European Central Bank meeting.

Thursday’s ECB gathering is shaping up as a more lively event than anticipated just a few weeks ago given that the central bank has flagged “early” 2018 for a revision of its policy guidance. That has sparked talk that the ECB could deliver an early rise in interest rates.

But a strong euro, which rose above $1.23 to its highest level since December 2014 on Wednesday, could encourage the central bank to play down talk of an imminent change in its policy stance.

The euro has gained 17 percent against the dollar since the start of 2017. Its strength puts downward pressure on inflation — making it harder for the ECB to achieve its near 2 percent inflation target.

“ECB President (Mario) Draghi’s priority will be to talk down growing expectations of early interest rate hikes and a strengthening euro,” said ABN AMRO senior fixed income strategist Kim Liu.

“We estimate that the recent euro strength will reduce the ECB’s projections for core inflation by around 0.1-0.2 percentage points. Against this background, we expect a dovish January ECB meeting, resulting in euro weakness and a short term correction in yields.”

Bond yields across the single currency bloc were 1 to 2 basis points higher on the day.

Southern European bonds, the big outperformers this week following ratings upgrades for Greece and Spain on Friday and overwhelming demand at a Spanish bond sale on Tuesday, were also slightly weaker.

The 10-year yield gap Spanish and Portuguese bonds hold over German peers were a touch wider, having hit their narrowest level since 2010 on Tuesday.

Peripheral euro zone debt markets have also benefited from a scaling back of rate-hike expectations following recent comments from ECB officials playing down a near-term shift in the bank’s policy stance.

Money markets price roughly a 40 percent chance of a 10 bps hike by year-end versus 70 percent earlier this month .

“The market has got a bit ahead of itself in pricing about a 40 percent chance of a rate rise this year,” said Mike Bell, global market strategist at JPMorgan Asset Management in a note.

“The focus will be much more on any communication hinting at what is likely to happen after September.”

A survey on Wednesday meanwhile showed French business activity began 2018 more strongly than expected.

Reporting by Dhara Ranasinghe; Editing by Robin Pomeroy

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