Lacklustre Italian auction weakens peripheral bonds
* Italian debt auction sees weak demand
* Bernanke says accommodative policy still needed
* Bunds rise, peripheral bonds weaken
By Marius Zaharia and Emelia Sithole-Matarise
LONDON, July 11 (Reuters) - Italian bond yields rose on Thursday after a lacklustre debt auction that suggested choppy trading caused by the Federal Reserve's mixed messages on ending stimulus is hurting demand for lower-rated euro zone debt.
After selling off in the previous session following Standard & Poor's downgrade of Italy's credit rating, peripheral bonds started on a strong footing on Thursday, with dovish comments from Fed Chairman Ben Bernanke lifting bonds and shares alike.
But also on Wednesday, minutes to the Fed's June policy meeting showed about half of the policymakers felt the central bank's bond-buying programme should be over by year-end, though many wanted reassurance the U.S. jobs recovery was on solid ground before any policy retreat.
Sentiment for lower-rated debt shifted after Italy sold its bonds at lower prices than those indicated by the secondary market and failed to raise the maximum amount planned at the auction, as Rome has at nearly all previous sales this year.
"We would have expected the positive sentiment for the periphery in today's opening ... to last a bit longer," RBC Capital Markets rate strategist Norbert Aul said.
"However, the auction shows that ultra-long peripheral bond supply is more difficult to digest in the current market environment. The ECB will have to continue to aim at reducing... volatility to avoid a negative impact on spread products."
Volatility affects investors' appetite for carry trades, in which they borrow money at low rates to invest in higher-yielding products. Such trades have helped drive this year's rally in peripheral bonds but can be affected by changes in the value of the underlying asset.
Italian 10-year yields last traded 4 basis points higher at 4.48 percent, having earlier fallen as low as 4.37 percent. Equivalent Spanish yields rose 3 bps to 4.81 percent, up from session lows of 4.70 percent.
Portuguese bonds were also weaker on the day, with 10-year yields rising as much as 10 bps to 6.99 percent, after the country's president rejected a continuity plan aimed at healing a rift within the governing coalition. Political uncertainty is threatening plans for Portugal to exit its bailout programme next year.
"DIFFICULT TO COMMUNICATE"
German Bunds ended higher as U.S. Treasuries extended the previous day's gains after Bernanke said accommodative monetary policy would be needed for the foreseeable future. The comments were perceived as a softening in tone after only weeks earlier the Fed laid out clear plans to trim its asset purchases.
A jump in weekly U.S. jobless claims also cast some doubts about the recent acceleration in jobs growth - seen critical in the Fed's decision whether to scale back its bond purchases.
Bund futures rose 35 ticks on the day to settle at 142.93., with 10-year cash yields down 2 bps at 1.63 percent.
When Bernanke first signalled plans to reduce stimulus in May, Bund yields traded around 1.30 percent, some 20 bps above their record lows. They then soared to around 1.85 percent in June before falling back some 25 bps.
"This volatility shows just how difficult it is for the Fed to communicate as it tries to exit quantitative easing," Commerzbank rate strategist Michael Leister said, adding that Bunds were likely to be increasingly volatile and sensitive to data releases.
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