July 18, 2019 / 3:12 PM / 5 months ago

UPDATE 1-Euro zone bond rally continues, bolstered by ECB rate-cut hopes

(Updates throughout, adds chart)

By Dhara Ranasinghe and Sujata Rao

LONDON, July 18 (Reuters) - Euro zone government borrowing costs slipped further on Thursday, though bond prices gave up some of their earlier gains after a robust U.S. factory reading sent U.S. Treasury yields higher.

German bonds, the benchmark for the single currency bloc, saw yields touch session lows after Bloomberg News reported that European Central Bank staff were studying a potential change to the bank’s inflation goal of near 2%.

Yields later rose off those levels, tracking U.S. Treasuries after a Philadelphia manufacturing index rebounded strongly in July, adding to recent data that shows an improving U.S. economy.

Still, 10-year Bund yields are down six basis points this week and are set for their biggest weekly fall since May, thanks to the promise of stimulus from the ECB, which some reckon may cut interest rates as early as next week.

The Bund yield slipped 2 basis points to minus 0.31% , off the earlier low of 0.327%

Southern European bond markets have benefited even more, and 10-year yields in Italy are on track for their seventh straight week of decline.

Rate cut hopes got a further boost after a Bloomberg report quoted sources as saying ECB staff were informally studying whether a more flexible target might be more appropriate.

That would potentially allow inflation to stay higher for longer than the bank would normally countenance.

“If it were to happen, then it would mean that the ECB would have to have rates lower for longer,” Peter Chatwell, head of rates strategy at Mizuho, said.

The ECB has failed to meet its inflation goal for years and recent dovish comments suggest it is again gearing up to cut rates and possibly even renew asset purchases to fight stubbornly low price growth and the headwinds from a global trade war.

The news briefly pushed the euro lower while euro zone stocks inched higher

VIVA ITALIA

Borrowing costs fell even more in southern Europe, viewed as the biggest beneficiary of ECB easing. Spanish, Italian and Portuguese 10-year bond yields were down 4-6 basis points on the day .

Italy in particular continues to shine, with 10-year yields falling to the lowest in more than three years at 1.506%, down more than 120 bps in the past two months.

The premium investors demand to hold Italian debt over Germany’s was the smallest in over a year at around 181 bps .

The rally got a further push on Thursday from the prospect of snap elections that could see a business-friendly centre-right coalition come to power.

Deputy Prime Minister Luigi Di Maio said the far-right League, his allies in the coalition, had to decide whether they wanted to quit the coalition or keep it going.

Tensions between the League and di Maio’s 5-Star Movement have increased this week after the League voted against Ursula von der Leyen as the new president of the European Commission, while 5-Star backed her candidacy.

“Any sense of an election in Italy is positive for Italian BTPs because investors think that the League could jettison the 5-Star Movement, leaving Italy with, on paper, a more business-friendly, centre-right government,” said Richard McGuire, head of rates strategy at Rabobank.

additional reporting by Abhinav Ramnarayan, Saikat Chatterjee and Josephine Mason; Editing by Kevin Liffey and Jan Harvey

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