February 16, 2018 / 11:37 AM / a month ago

UPDATE 3-German 10-year bond yield drops to one-week low, inflation jitters linger

* German 10-year bond yields drops to 0.699 percent

* Euro zone bond yields still set to end week higher

* U.S. 2-year yields set for biggest weekly rise in almost a year

* Euro zone periphery govt bond yields - tmsnrt.rs/2ii2Bqr (Adds in German 10-year Bund yield low)

By Dhara Ranasinghe and Fanny Potkin

LONDON, Feb 16 (Reuters) - Euro area borrowing costs fell on Friday, with Germany’s 10-year yield dropping to a one-week low, though expectations for higher inflation and steps towards tighter monetary policy from major central banks weighed on sentiment across world bond markets.

Short-dated bond yields in Germany have risen about 7 basis points this week and were set for their biggest weekly rise in eight weeks.

In the United States, where data on Wednesday showed consumer prices rose more than expected in January, interest-rate sensitive two-year Treasury yields were set to end the week up 13 bps - the biggest weekly rise in almost a year.

As investors bet the U.S. Federal Reserve could deliver more rate increases than expected this year, bond yields have risen even as stock markets have appeared to shrug off the inflation numbers.

“It has been a U.S. story this week, with the CPI data prompting markets to price in more rate hikes from the Fed,” said Mizuho rates strategist Antoine Bouvet.

Expectations for a May rate rise from the Bank of England have also shot up in the past week, while strong economic growth data adds pressure on the European Central Bank to signal a step away from ultra-loose monetary policy.

Economists polled by Reuters believe that the ECB will end its asset-purchase programme by the end of the year and then wait six months before raising interest rates.

ECB board member Benoit Coeure on Friday said the bank is not overly concerned by the recent bout of volatility in global markets because the adjustment has been orderly and the impact largely contained to equities.

Nevertheless, there was a slightly firmer tone to bond markets on Friday, which analysts attributed to some position-squaring ahead of a long U.S. weekend, with markets shut on Monday for the President’s Day holiday.

Ten-year bond yields across the euro zone were 2-5 bps lower on the day.

Germany’s 10-year bond yield dropped to as low 0.699 percent in late trades, down 7 basis points on the day. It was its biggest one day fall since mid-December.

Two-year German bond yields were steady at minus 0.50 percent, having hit their highest since May 2016 on Thursday at about minus 0.47 percent.

“The trend is still for higher bond yields,” said Orlando Green, European fixed-income strategist at Credit Agricole.

Southern European bonds in particular outperformed, with Portuguese and Italian 10-year bond yields both hitting a one-week low.

Italy’s 10-year bond yields dropped by almost 7 bps to as low as 1.984 percent.

Italian Prime Minister Paolo Gentiloni said on Friday he did not see a risk of an anti-Europe government taking shape after national elections on March 4.

However, a batch of final opinion polls pointed to possible political deadlock, indicating that while Silvio Berlusconi’s centre-right bloc has a clear lead, it is unlikely to win a working majority.

There was also focus on Greece, with Fitch Ratings due to release its latest review on the indebted southern European state late on Friday.

Fitch rates Greece B- with a positive outlook. In January S&P lifted Greek long-term ratings for the first time in two years.

Reporting by Fanny Potkin and Dhara Ranasinghe; Editing by David Goodman and Hugh Lawson

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