Bunds firm as Syrian conflict fuels flight to safety

LONDON Wed Aug 28, 2013 3:23am EDT

LONDON Aug 28 (Reuters) - German government bonds firmed on Wednesday as increasing prospects of a military strike by Western powers in Syria led investors to snap up safe-haven assets.

"Syrian fears are growing by the minute and that should keep (Bunds) underpinned. It is hard to tell whether this will be more than a short-term blip at the moment," one trader said.

The "risk-off trade" affected higher-yielding debt, especially Italy, which was looking "wobbly politically," he said.

Bund futures rose 25 ticks to 140.79, having risen half a point in the previous session. Ten-year German yields fell 3 basis points to 1.824 percent, drifting further away from Friday's 1-1/2 year highs of 1.98 percent.

Fixed income analysts said the flight to safety was triggered by the risk that the conflict could escalate into a regional one and, even though oil prices were rising, concerns about global growth were less acute for the moment.

Therefore, the prospect of U.S. monetary stimulus reduction as early as next month and the improved economic outlook in the euro zone limited Bund gains.

"As it happens many times with these conflicts, the risks will probably be priced in beforehand and markets could reverse course even before the first bomb is dropped," said Jan von Gerich, chief strategist for developed markets at Nordea.

"Gradually, the focus will shift more to the U.S. data again."

Bunds and other highly-rated euro zone debt firmed, while lower-rated bonds weakened.

The yield gap between Italian and German 10-year yields widened slightly to 262 bps, more than 30 bps above the two-year lows it hit mid-August.

Italian bonds have been hit by political tensions in the past week, with a looming vote on whether to expel former premier Silvio Berlusconi from parliament raising concern about the stability of the ruling coalition.

Italy holds a cabinet meeting on Wednesday to reach agreement on a controversial housing tax.

The shaky political situation has narrowed the gap between Italian and Spanish 10-year yields to about 2 bps on Monday, its tightest in 1-1/2 years. The spread was last at 5 bps.

"In the very near term Spanish bonds are going to continue to outperform," von Gerich said. "But the trade... is increasingly becoming almost a consensus so the risk is that we see a reversal at some point."

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