Euro zone bonds inch higher on ECB policy easing bets
* Low inflation puts pressure on ECB to ease policy
* Euro zone bond yields fall broadly
* Yield curves steepen as short-term yields fall more
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Nov 1 (Reuters) - Euro zone bonds broadly edged higher on Friday, extending this week's rise after a surprisingly sharp slowdown in euro zone inflation raised expectations that the European Central Bank may ease monetary policy further.
October inflation fell to 0.7 percent from 1.1 percent the previous month, well below the ECB's target of just under 2 percent, data on Thursday showed. The shock was so great that it overshadowed a Federal Reserve statement that was perceived as less dovish than anticipated.
Short-term euro zone inflation gauges as measured by French breakeven rates, the yield spread between euro zone inflation-protected government bonds and equivalent nominal debt, have plumbed to July lows since the report.
Many in the market expect the ECB at least to signal a rate cut or new liquidity injections at its meeting next week, while holding fire until December when it will have updated medium-term inflation and growth forecasts.
"Inflation is so low that you just have to assume they'll do something about it," said Alan McQuaid, chief economist at Merrion Stockbrokers. "That's going to keep the (bond) markets well bid going into the ECB meeting."
Shorter-dated bond yields, more sensitive to central bank policy than the longer-dated ones, fell the most.
Two-year Spanish yields fell 6 basis points to 1.09 percent, while equivalent Italian yields dropped 5 bps to 1.39 percent. Their 10-year counterparts fell by 2 bps to 4.02 and 4.11 percent, respectively.
In core euro zone bonds, German two-year yields , were 1 bp lower at 0.11 percent, their lowest since Aug. 1, steepening the 2- to 10-year yield curve by 3 bps to 158 bps. Bund futures closed 15 ticks lower at 141.85, having hit a two-month peak of 142.32 on Thursday.
Longer-dated Bunds tend to track their top-rated peers, the U.S. Treasuries, more closely and therefore the Fed outlook has more influence on them.
A stronger-than-expected report on U.S. manufacturing reduced pessimism about the economic recovery, reviving some worries the Federal Reserve might pare its bond purchases earlier than some traders had thought.
"The market is now strongly expecting the ECB to deliver something by the December meeting so the front end is extremely well bid," a trader said. "Longer-dated Bunds to some degree are going to trade with a bit of a bias towards what Treasuries will do after the Fed was not so dovish."
The ECB has not sent any official signals of imminent easing since its October meeting and were it to make such a move, it is unclear whether it would opt to cut rates or prefer to give banks another dose of cheap long-term loans.
Societe Generale strategists said in a note they expected the central bank to cut interest rates to a record low 0.25 percent from the current 0.50 percent in December.
"From the ECB perspective, a key rate cut would weigh on the euro/dollar near term and help anchor inflation expectations that otherwise could drop sharply," they said.
"However, it is doubtful that a rate cut alone would have a lasting effect on the euro exchange rate and an LTRO (programme of cheap loans) would probably have a bigger effect."
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