August 29, 2017 / 7:48 AM / a year ago

UPDATE 3-German bond yields drop after N.Korea missile test, euro surges

* North Korea missile test boosts safe-haven German bonds

* German two-year “Schatz” yields sink to 4-month low

* Euro hits $1.20, adds downward pressure on yields

* Euro zone periphery govt bond yields (Updates prices, graphic)

By Abhinav Ramnarayan

LONDON, Aug 29 (Reuters) - Germany’s borrowing costs hit their lowest level in months on Tuesday as investors rushed to buy up one of the safest securities in the world after North Korea fired a ballistic missile over Japan.

North Korea’s ballistic missile test early on Tuesday prompted warnings for residents to take cover while provoking a sharp reaction from Japanese Prime Minister Shinzo Abe and other leaders.

“We are seeing a classic risk-off pattern after Pyongyang fired the ballistic missile,” said DZ Bank analyst Rene Albrecht, pointing to U.S. Treasuries, German Bunds and gold as examples of safe-haven assets that were in demand on Tuesday.

The yield on Germany’s 10-year government bond , the benchmark for the euro zone region, fell 3 basis points to 0.34 percent, its lowest since June 28.

U.S. equivalents dropped to their lowest since last November at 2.086 percent, while Japan’s fell to zero percent for the first time since April.

The yield on short-dated German “Schatz” bonds, sank further into negative territory, hitting its lowest level in over four months at minus 0.76 percent.

However, this had the effect of making an auction of two-year bonds less attractive, and the German debt agency fell short of its target of selling 5 billion euros of new bonds.

The German Finance Agency, the federal government’s debt management office, sold 4.03 billion euros of its new 0.00 percent Schatz notes at an average yield of minus 0.74 percent, the Bundesbank said on Tuesday.

In keeping with the jittery mood, riskier assets underperformed on Tuesday.

The gap between lower-rated Southern European government bond yields and their better-rated counterparts increased, and Italy’s 10-year bond yield spread over Germany widened 6 basis points to 177.5 bps, the widest since mid-July.

“In times of higher political tensions, there is more demand for Bunds than for peripheral bonds,” said Albrecht of DZ Bank.

A stronger euro also put downward pressure on euro zone government bond yields.

The single currency hit $1.20 for the first time since January 2015 on Tuesday, adding to an expectation that reduced import prices may keep inflation low and delay the European Central Bank’s withdrawal of stimulus.

“Euro strength is putting resilient inflation expectations to the test and likely signs for slipping HICP core inflation over the coming days should further weigh on break-evens,” Commerzbank analysts said in a note.

A gauge of long-term inflation expectations in the euro zone, the five-year forward rate, has been trading at around 1.59 percent, well below the ECB’s target for less than 2 percent.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=

Reporting by Abhinav Ramnarayan; Editing by Richard Balmforth and Raissa Kasolowsky

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