Euro zone bonds firm as low inflation spurs ECB easing bets
* Euro zone inflation falls way below ECB target
* Fed statement "not as dovish" as markets expected
* Nowotny says ECB will provide more liquidity
By Marius Zaharia
LONDON, Oct 31 (Reuters) - Euro zone government bonds firmed on Thursday after inflation unexpectedly slowed in October, increasing chances that the European Central Bank could ease monetary policy further.
Data showing inflation fell to a four-year low of 0.7 percent, way under the ECB's target of just below 2 percent, reversed an early dip in bond prices caused by the Federal Reserve being less alarmed than anticipated about the U.S. economy in its post-meeting statement.
Investors had expected inflation to steady at 1.1 percent and some analysts said the surprise drop raised the likelihood that the ECB would at least flag a rate cut or further liquidity injections at its meeting next Thursday.
"It was pretty far from consensus and this is something that could help the doves inside the ECB board ... Even the Germans could be worried about the decline in inflation," said Sergio Capaldi, fixed income strategist at Intesa SanPaolo in Milan.
He did not expect the ECB to make a move as early as Thursday, however, as the bank has not sent any clear signals of imminent easing since its last meeting.
Governing Council member Ewald Nowotny earlier said the ECB will provide more liquidity to banks by the time the cheap three-year crisis loans offered in late 2011 and early 2012 expire, but he declined to specify how and when.
Bund futures rose to their highest since Aug. 12 at 142.28 after the inflation data, having earlier traded as low as 141.52. Cash 10-year Bund yields, the region's benchmark, fell 4 basis points to 1.65 percent, their lowest since Aug. 8.
Other data on Thursday including below-forecast German retail sales and French consumer spending and record high euro zone unemployment also supported expectations of further ECB easing.
Those prospects lifted lower-rated debt as well, with Spanish 10-year yields falling to their lowest since May 3 at 3.99 percent and equivalent Italian yields dropping 6 bps to 4.12 percent.
The euro zone data outweighed the impact of the statement the Fed gave on Wednesday at the end of its two-day meeting.
The U.S. central bank kept its $85 billion-a-month asset purchase plan intact, acknowledging the negative impact that a recent standoff over the U.S. budget would have on the economy and the fact that a recovery in the housing market had slowed.
But it removed a reference to tighter financial conditions from its statement, suggesting greater comfort with the current level of market rates.
"(The Fed statement) was still dovish, but maybe not as dovish as the market was positioned for," said Patrick Jack, rate strategist at BNP Paribas in Paris.
Sanjay Joshi, head of fixed income at London and Capital, said he still expected the Fed to hold off from trimming stimulus until April. "But views in the market are very dispersed - some are going for December," he said.
He added the mix of views could make longer-dated bonds more data sensitive and volatile, so he cut the overall duration of his bond portfolio.
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