EURO GOVT-Hefty ECB repayment pummels German two-year bonds
* Short-dated yields rise to multi-month highs
* Size of bank repayment to ECB is bigger than forecast
* Markets bet on more aggressive liquidity withdrawal
* Two-year U.S. yields rise above U.S. counterparts
By Marius Zaharia and Ana Nicolaci da Costa
LONDON, Jan 25 (Reuters) - Two-year German bond yields hit their highest since March 2012 On Friday, rising above their U.S. counterparts, after the ECB said banks would pay back a greater-than-expected 137 billion euros in loans next week.
The repayment was higher than the 100 billion euros ($134 billion) forecast in a Reuters poll - a sign that at least parts of the financial system are returning to health.
Short-dated debt led a rise in yields across maturities, with German bond prices having already come under selling pressure after stronger-than-expected data boosted optimism about the outlook for the euro zone's largest economy.
"It (the repayment amount) helped the Schatz yield higher, but it is more of a symptom rather than the cause. The euro zone situation has improved quite nicely," said David Keeble, global head of fixed income strategy at Credit Agricole.
Two-year German yields rose 8.4 basis points to 0.261 percent. Keeble said they could rise further, but probably not by more than 5 bps in the next three months as markets still do not expect the ECB to raise rates any time soon.
On Friday, they overtook the premium offered by two-year U.S. bonds for the first time in two years.
Some analysts said the higher-than-expected number was prompting markets to price in a more aggressive repayment of the European Central Bank funds, sapping the abundant liquidity that helped calm the euro debt crisis in late 2011 and early 2012.
"Clearly this is putting some pressure on the front end of the euro zone curve, given that the market is extrapolating this larger repayment and taking the view that excess liquidity is going to fall more quickly than initially expected," Michael Leister, senior interest rate strategist at Commerzbank, said.
Five-year German yields rose 10 basis points to 0.66 percent - its highest since October 2012 - and 10-year yields were 6 bps higher at 1.575 percent.
Yields were already higher before the announcement, as data confirmed a rebound in the euro zone's largest economy.
Munich-based think tank Ifo said German business morale improved for a third consecutive month in January to its highest in more than half a year.
One day after upbeat private sector activity data, the Ifo numbers prompted investors to dump safe-haven assets even as data showed Britain's economy contracted more than expected in the fourth quarter.
Bund futures fell 75 ticks on the day at 142.45.
KEEP CALM AND CARRY TRADE
Spanish borrowing costs over 10 years were down 8.4 bps at 4.94 percent and the Italian equivalent shed 3.4 bps lower to 4.12 percent.
"I doubt there were many peripheral banks taking part in that pay-back," said Christian Lenk, strategist at DZ Bank.
"For the periphery, most of them should have taken the money from the ECB to buy Italian and Spanish debt for carry and I doubt they have an incentive to pay back the LTROs (long-term refinancing operations) right now."
"Carry" refers to investors borrowing at the ECB cheaply to put money in higher yielding bonds and make a profit.
While domestic banks are willing to keep hold of debt issued by their governments, some foreign investors are wary of adding Italian and Spanish bonds to their holdings after a steep fall in yields since the ECB's bond-buying pledge in September.
Sanjay Joshi, head of fixed income at London and Capital, said he was starting to sell some of the peripheral debt he had bought in the past two to three months.
"The (ECB money) being returned is a sign of confidence in the financial health of the periphery," said Joshi, whose firm manages fixed income assets worth $1.5 billion.
"But deep in the background, unemployment is still rising, non-performing loans are rising, as well and housing prices are falling."
Italy's February elections could also shake investor confidence, he noted.