Greek yields fall as hurdle to bailout talks seen resolved
* Greek yields extend this week's falls
* Greek 2014 fiscal gap issue largely resolved-sources
* German yields steady near six-month lows as ECB eyed
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Feb 4 (Reuters) - Greek yields fell on Tuesday on news that Athens and its foreign lenders had largely resolved differences over a potential fiscal gap this year, removing a hurdle to talks to release more bailout funds.
A review of progress under its EU/IMF bailout has dragged on since September, largely due to wrangling over how Athens would plug a gap in this year's budget. Surprisingly strong data on a primary surplus for 2013 helped to resolve this issue, sources on both sides of the negotiations told Reuters.
Greek 10-year yields fell 10 basis points to 8.37 percent on the report, outperforming euro zone peers, albeit in thin liquidity. The yields have been retreating from 2014 peaks since Monday after Germany denied suggestions that private bondholders could suffer further losses in a potential new aid programme.
"Any developments that increase the chances of payments from the existing bailout continuing and providing Greece with further support while the restructuring of the economy takes place is obviously a positive," said Ben May, European economist at Capital Economics.
Greece has no pressing funding needs until May, when bond payments of 9.3 billion euros are due. It has already been bailed out twice with 240 billion euros from the EU and IMF since 2010 and is expected to need additional funds and debt relief before it can get on its feet again.
Although its 10-year yields have been falling sharply this week, they still remain 35 bps above those of 30-year bonds, reflecting investor concern they may not get repaid in full.
Elsewhere, German 10-year yields ended flat at 1.55 percent, having hit a six-month low of 1.534 percent on talk the European Central Bank was seeking support to stop sterilising its crisis-era bond purchases in money markets.
The ECB takes an amount equivalent to its holdings of euro zone government bonds as weekly deposits from banks to offset the buying and neutralise any threat it will fuel inflation.
The weekly operations are also aimed at quelling concerns the bond purchases were directly financing governments, something the ECB is not allowed to do.
A Bloomberg report, citing two euro-area central bank officials familiar with the debate, said ECB President Mario Draghi would only consider ending the sterilisation if he is openly backed by the Bundesbank.
People familiar with the issue told Reuters that the ECB had discussed the possibility of suspending the operation but this was just one policy option and was unlikely to be decided at its meeting on Thursday.
"If the ECB were to follow that path and go for a suspension and not termination, it's a pragmatic way to add liquidity to the system rather than introduce a new three-year LTRO (Long-Term Refinancing Operation)," said Marius Daheim, a strategist at Bayerische Landesbank.
"That may be a bit more difficult for the ECB to manoeuvre in the current setting where banks are repaying LTROs. We don't think there will be very strong demand for another LTRO."
The ECB successfully soaked up the 175.5 billion euro in bond purchases it was aiming for on Tuesday, 24 billion euros more than last week. It also allotted banks 20 billion euros less in its weekly refinancing operation, further squeezing the amount of excess cash in the system.
In recent weeks it failed to sterilise the entire amount with traders saying banks preferred to hold on to the funds rather than hand them back to the ECB. That was because excess liquidity - the amount of cash banks have beyond what they need for their day-by-day operations - hovered around two-year lows.
The drop in excess liquidity led to increased volatility in overnight bank-to-bank borrowing rates in January as some banks, less reliant on ECB funds, had to be more active in money markets. If the ECB stopped sterilising, the excess liquidity in the banking system would rise by almost 180 billion euros.
It would keep money market rates anchored at low levels, preventing a tightening of market conditions that could hamper the euro zone economic recovery, analysts said.
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