January 25, 2018 / 9:02 AM / a year ago

Euro zone yields dip as euro surge blunts inflation bets ahead of ECB meet

* Euro zone yields lower 1-2 bps as ECB meets on Thursday

* Spanish Portugues bond yield spreads tightest in years

* Euro scales $1.24, denting inflation expectations

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

By Abhinav Ramnarayan

LONDON, Jan 25 (Reuters) - Euro zone government bond yields edged off recent peaks hours before the European Central Bank meeting, on expectations that a surging euro would hamper inflation and make it hard for policymakers to withdraw stimulus too sharply.

Yields on most euro zone government bonds, particularly the higher-rated ones, have risen in recent weeks as a booming euro zone economy fuels inflation expectations and bets that the ECB would withdraw its 2.55 trillion euro bond-buying scheme and hike rates sooner rather than later.

But a strengthening euro is taking the edge off that trend; a stronger currency tends to pull consumer prices lower as import costs are reduced.

The single currency scaled $1.24 overnight for the first time in over three years, crowning a stellar rise over the past 2-1/2 months from $1.1608 in the first week of November.

A market gauge of inflation expectations closely watched by the ECB, the five-year five-year forward breakeven rate , closed Wednesday at 1.765 percent, down from 1.78 percent earlier in the week.

This has prompted investors to bet that the ECB will strike a more cautious tone when it meets later on Thursday on potential rate rises and withdrawal of its bond-buying scheme.

“Even with no update to the staff (inflation) forecast due before March, the potential impact on growth and inflation is likely to prompt a reaction at the ECB today,” Mizuho analysts said in a note.

ECB President Mario Draghi could use the press conference that follows the meeting to stress that the euro appreciation has been in excess of what is warranted by fundamentals, or to push back against rate hike expectations, the analysts said.

Consequently, euro zone bond yields — which move inversely to price — dropped 1-3 basis points across the board on Thursday.

The yield on Germany’s 10-year government bond , the benchmark for the region, was lower 1.6 bps at 0.515 percent, moving further off the recent five-month high of 0.54 percent hit in early January.

Low-rated Spanish, Italian and Portuguese government bonds, seen as the biggest beneficiaries of ECB largesse, slightly outperformed the rest of the market with yields lower 2-3 bps.

The Portugal-Germany bond yield spread at one stage was at its tightest since March 2010 at 116.5 bps while the equivalent Spain-Germany spread was at its tightest since April 2010 at 83 bps.

“The most interesting thing for this meeting will be exactly how they are going to try and clarify some of their comments that came out after the December minutes that were interpreted as hawkish,” said Alessio de Longis, portfolio manager for OppenheimerFunds’ global multi-asset group.

“The ECB will be mostly focused on managing the rise in bond yields and the rise in the currency, because both of them will lead to a tightening in financial conditions that will occur before they get to an actual exit strategy.”

Reporting by Abhinav Ramnarayan, Additional reporting by Fanny Potkin, Editing by William Maclean

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