German Bunds extend gains as market prices in Syria strike
* Bund yields drift further away from 1-1/2 highs
* Fed, euro zone outlook limit Bund gains
* Some investors take profits on Spain vs Italy trades
By Marius Zaharia
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.
The Bund's gains were more limited than on Tuesday, suggesting markets are readjusting to a factor in a strike, and only a broader escalation of the conflict would fuel significantly more flows into Bunds.
Bund futures rose 23 ticks to 140.77, having gained half a point in the previous session. Ten-year German yields fell 1.5 basis points to 1.84 percent, drifting further away from Friday's 1-1/2 year highs of 1.98 percent.
Lower-rated euro zone debt was flat to slightly weaker.
"The German curve looks pretty flat, which means investors have priced in the geopolitical uncertainty," said Luca Cazzulani, rate strategist at UniCredit. "If the international situation becomes more severe, risk assets could get hit more."
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 a cut in U.S. monetary stimulus as early as next month and the improved economic outlook in the euro zone capped 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."
ITALY VS SPAIN
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.
That has driven the yield premium offered by Italian 10-year bonds over benchmark German Bunds to more than 30 bps above the two-year lows it hit in mid-August.
But the gap stabilised around 261 bps on Wednesday, as some investors who have bet Italian bonds will lag Spanish ones took profits on the trade as the yield spread between them came close to reversing on Tuesday, traders said.
The Spanish/Italian 10-year yield gap was last at 8 bps, after hitting its tightest in 1-1/2 years at 2 bps on Tuesday.
"We see a bit of a reversal of what we had yesterday, but despite today's strength I still expect Italy will continue to underperform Spain because of the Berlusconi situation," ING rate strategist Alessandro Giansanti said.
He estimated Italian yields could trade 5 bps higher than the Spanish ones near-term if political uncertainty lingers.
Italy holds a cabinet meeting on Wednesday to reach agreement on a controversial housing tax.
Positioning for upcoming debt auctions has also weighed on Italian bonds recently. Italy plans to sell up to 6 billion euros of five- and 10-year bonds on Thursday.
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