EURO GOVT-Signs of Greek progress send German bonds tumbling
* Bunds set for biggest weekly fall since late November
* Scope for further relief limited, capped by technical levels
* Greek talks progress buoys sentiment; Italy, Spain outperform
LONDON, Jan 20 (Reuters) - A second straight session of steep losses left German Bund futures on track for their biggest weekly fall in nearly two months as markets anticipated Greece would strike a deal on debt writedowns.
Signs of progress in negotiations between Greece and its creditors over how much of the country's crippling debt can be written off looked to be edging towards a conclusion, easing the likelihood of a disorderly default in March.
That prompted a shift out of safe havens, sending Bund futures down by over a point to their lowest in two weeks at 137.86 and helping Italian and Spanish and other peripheral bonds to extend their recent outperformance.
"We've been building confidence in Greece and the IIF (Institute of International Finance) arriving at some conclusion over the last two sessions," said Peter Chatwell, rate strategist at Credit Agricole in London.
The shift out of safe-havens and into riskier assets would probably continue if a deal did materialise, but with the success of a deal still dependent on successful implementation, moves could be limited in size.
"We can't really go selling off Bund futures too hard and getting too optimistic because there's still more twists and turns yet for this tale to take," Chatwell said.
For an overview of the possible outcomes of the Greek debt talks see
Bund futures should find technical support at the year's low of 137.70 while the rise in cash market yields could be limited by the psychological 2 percent barrier. Ten-year German bond yields rose 7 bps on the day to 1.93 percent.
Even a smooth implementation of the debt swap would not necessarily ease the outlook for Greece and see investors abandon their heavy investment in low-return, but safe and liquid German Bunds.
"We would argue the continued shrinkage of Greek GDP has the potential to rapidly erode any advantage the state hopes to gain from the proposed haircuts. As such, this could well be the first rather than last restructuring effort," said Rabobank strategist Richard McGuire.
Beyond Greece, lower-rated euro zone bonds outperformed German debt. Italian 10-year yields were 9 basis points lower on the day at 6.3 percent, extending their sharp fall from levels above 7 percent seen two weeks ago.
Spanish yields also fell, reflecting the positive sentiment prompted by the ECB's huge injection of cash into the banking sector - some of which has been used to buy peripheral debt and has helped support recent bond auctions.
Portuguese debt was steady on the day despite concerns that the country could fall victim to contagion from any Greek deal. Although Lisbon sealed a labour reform deal this week, some are wary that Greek debt writedowns could be used as a template for solving Portugal's debt problems.
The outperformance in peripheral debt could continue next week, analysts said, in the absence of any long-term bond supply pressure from the region's lower-rated states.
Germany and the Netherlands dominate next week's supply schedule, with Italian sales of zero-coupon and inflation-linked bonds providing the only peripheral debt for the market to digest.
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