EURO GOVT-Bund selloff stabilises, ECB repayment effect not over
* German debt prices stable after steep selloff on Friday
* ECB loan repayments set to drive short-term yields higher
* Rise seen gradual as demand for safe havens persists
LONDON, Jan 28 (Reuters) - German bond yields were steady on Monday but looked set to creep higher over the medium term as banks repay emergency loans from the European Central Bank early and drive up money market rates.
The ECB announced on Friday that 137 billion euros of three-year banking sector loans would be repaid early.
That amount exceeded expectations and was taken as a sign that areas of the banking system were recovering and that money market rates would rise. It dented safe-haven demand for long-term German debt and caused a selloff in short-dated bonds.
The move slowed on Monday with Bund futures trimming an early fall to trade 11 ticks lower at 142.39 while two-year German yields were half a basis point higher at 0.264 percent after an 8 basis point rise on Friday.
Traders said the slowdown in the selloff was natural given the large scale of Friday's moves, with some cautious investors attracted back into the market at cheapened levels and others closing out trades that profited from the fall.
"It looks like there's some profit taking from the fast money guys who were short going into Friday, so I'm not surprised to see us ticking up off the lows," a trader said.
Longer-term, though, the prospect of excess cash draining from the system could keep upward pressure on yields, with banks now having the opportunity to repay cash on a weekly basis.
In theory, the less surplus cash in the system, the more banks have to compete to secure funds, driving short-term rates higher, generating a knock-on effect into bond markets.
ING rate strategist Alessandro Giansanti said two-year yields could rise as high as 0.4 percent as market conditions normalise over the coming months, with the impact on the longer-end of the curve smaller at around 10 basis points. Ten-year yields were last at 1.59 percent.
Focus will now turn to weekly repayments to see if banks continue returning the cash and particularly on Feb. 27, which for the first time will include repayments from the second of two long-term borrowing operations held a year ago.
After Friday's initial adjustment, moves were expected to be much slower over coming sessions, with plenty in the market who believe the risks remaining in the euro zone still warrant investment in safe haven assets.
"There's still a lot of uncertainty regarding the economic recovery in Europe... and there's some structural problems that don't solve too easily. We're still not in a situation where investors are switching out of the Bund safe-haven," said Elwin de Groot, strategist at Rabobank in Utrecht.
Italy began a busy week of issuance by launching new zero coupon and inflation linked bonds worth a total of 6.63 billion euros which raised close to the treasury's maximum target and showed that appetite for higher-yielding bonds remained intact.
New inflation-linked bonds are typically issued using a syndicate of banks who underwrite the deal in advance - making sure the bonds are sold - but Italy opted to avoid the extra expense and use an auction.
"The auction was allocated without problem. The market's perception... in the linker sector was quite good. Issuing new linkers by regular auction is a strong signal," said Chiara Manenti, strategist at Intesa SanPaolo.
The auction augurs well for Wednesday's planned sales of five and 10-year bonds which could net the Treasury up to 6.5 billion euros and, based on Reuters data, take Italy's funding close to 18 percent of its full-year target within January.
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