Spanish yields hit six-month lows on Fitch outlook upgrade
* Fitch upgrades Spain outlook to stable from negative
* ECB easing speculation supports euro zone bonds
* Some say ECB may be running out of monetary easing tools
By Marius Zaharia and Emelia Sithole-Matarise
LONDON, Nov 4 (Reuters) - Spanish 10-year yields hit six-month lows on Monday after Fitch upgraded its ratings outlook, in a market underpinned by bets the European Central Bank could signal further monetary easing this week.
Fitch revised on Friday Spain's credit ratings outlook to stable from negative, citing progress in cutting the deficit and a sooner-than-expected return to growth.
Profit-taking took hold as soon as Madrid announced plans to sell 3-4 billion euros of 2018, 2023 and 2026 bonds on Thursday, with investors making room in their books for the new paper.
Spanish 10-year yields ended the day flat at 4.02 percent, having fallen as low as 3.961 percent earlier.
"The Fitch release at the end of the week on Spain's outlook was clearly welcomed by the market," said Matteo Regesta, a strategist at Citi.
Core and lower-rated euro zone bonds rallied in the past week after a sharp fall in inflation firmed up market bets the ECB will ease policy further in coming months.
Surveys showing factory activity in the region accelerated as expected in October did little to change investors' views on the ECB, as shrinking manufacturing in France hampered a robust recovery.
In core markets, German Bund futures rose 4 ticks to 141.89, having hit two-month highs at 142.32 last Thursday. Cash 10-year Bund yields fell 1 bps to 1.68 percent and Dutch, French and Austrian yields also dipped.
While speculation of ECB easing policy on Thursday - either through a rate cut or another injection of unlimited long-term loans to banks - is rife, all but one of the 23 traders polled by Reuters expect the ECB to remain on hold.
"What markets really have been saying over the past few days is that they now think a greater probability should be assigned to (a rate cut)," Investec chief economist Philip Shaw said.
The exact probability is hard to pin down due to distortions on 2013 money market rates created by the excess liquidity in the euro system injected mainly through three-year ECB crisis loans to banks. Although falling, the excess cash remains ample.
But longer-rated rates seem to paint the picture of another ECB easing move in the future. The one-year, one-year Eonia forward rate, which shows where markets see one-year Eonia rates in one-year's time, hit a three-month low of 0.248 percent on Monday - a 10 bps fall from levels seen before last week's inflation figures and less than half the levels seen in early September.
That implies that in the next two years markets either expect the ECB to prevent the excess liquidity from evaporating or they price in a 25 basis point rate cut to 0.25 percent.
When excess liquidity in the market is insignificant, Eonia rates tend to trade closer to the ECB's refinancing rate. The overnight Eonia rate for December traded around 0.12 percent.
While a rate cut would have little impact on the economic outlook, bond markets may react positively to it if they see it as the last step before new unconventional measures.
"It would be a signal that you go after the disinflation problem with gusto using your last (conventional) tool and this could flatten the (euro zone yield) curves up to five years quite nicely," said David Keeble, global head of fixed income strategy at Credit Agricole in New York.
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