Looming bond sale, Middle East tensions lift Spanish debt premium
* Middle East uncertainty keeps markets volatile
* Spanish debt premium briefly falls close to 2-year lows
* Fed tapering prospects have little impact on periphery
By Marius Zaharia
LONDON, Sept 3 (Reuters) - Positioning for a debt sale and uncertainty over tensions in the Middle East lifted the premium for lending to Spain from levels that were close to the lowest in two years on Tuesday, offsetting the impact of an improving economic outlook.
Data on Monday showing the European manufacturing sector beating expectations pushed the difference between yields on Spanish 10-year debt and equivalent German Bunds to as low as 246 basis points in early trade.
Any further narrowing would have taken the yield gap to its tightest since July 2011, but investors used the rally to make room in their books before a Thursday auction of up to 4 billion euros of Spanish five- and 10-year bonds.
Reports that Russia detected two ballistic objects above the Mediterranean also kept markets wary of any escalation of tensions in the Middle East even as Moscow said the objects fell into the sea.
"We had a domestic player buying quite heavily first thing this morning, but then the market did what it had to do and went into natural profit taking and positioning for the auction," one trader said, adding that the reports from Russia "realerted people about the geopolitical risks," hurting riskier assets.
The Spanish/German 10-year yield gap was last flat at 253 bps, while the Spanish/Italian spread widened by 4 bps to 12 bps in a sign of supply pressure, having hit the tightest in 1-1/2 years at 2 bps last week on increasing political risks in Italy.
A looming vote on whether to expel former Prime Minister Silvio Berlusconi from parliament after his conviction for tax fraud risks bringing down the left-right ruling coalition.
"I expect the convergence (between Spanish and Italian yields) to continue after the supply gets out of the way due to the political risks in Italy," KBC rate strategist Mathias van der Jeugt said.
With strong support from domestic investors, Spain and Italy have withstood the broad selling pressure on risky assets caused by expectations the Federal Reserve could start trimming monetary stimulus this month.
The better than expected data has also raised doubts about the European Central Bank's promise to keep rates low for a long time, but analysts do not expect a shift in policy just yet.
"We had a sell-off (in May) when people started to realise that the cheap money (from the Fed) is disappearing," ING rate strategist Alessandro Giansanti said.
"But after the initial shock investors also started to realise that this is because fundamentals were improving."
Safe-haven German Bunds were little changed, with investors watching U.S. President Barack Obama's efforts to persuade lawmakers to attack Syria.
Ten-year yields were flat at 1.904 percent, keeping close to the 1-1/2 year highs of 1.98 percent hit last month before the conflict in Syria escalated.
Some analysts say they are likely to rise further soon, especially given that this week's top-rated debt sales in Germany and France are not supported by redemption flows.
Austria sold 1.5 billion euros of 2023 and 2044 bonds on Tuesday.
"These yield levels of core paper may seem to those who are focusing on a euro zone crisis ... to be generous," Credit Agricole rate strategist Peter Chatwell said in a note.
"But on the basis of a forward-looking market, e.g. PMI-led and adapting to developed economies which are growing, and this week's net cash drain, we would not be surprised if the 10-year Bund yield was to trend upwards to test 2 percent."
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