Spanish, Italian yields hold near 8-yr lows before inflation data

LONDON Fri Feb 28, 2014 3:37am EST

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LONDON Feb 28 (Reuters) - Spanish and Italian bond yields held near eight-year lows on Friday before euro zone inflation data which could increase expectations the ECB could ease monetary policy further, possibly as early as next week.

Worries the euro zone might fall into a Japan-like deflationary spiral that could cripple its growth prospects for a prolonged period have been rising, leading many in the market to predict more European Central Bank action.

A third of the economists polled by Reuters saw a cut in interest rates at next Thursday's meeting, while a growing minority expect the ECB to eventually purchase government bonds and print money.

For government bond markets this means top-rated German yields remain anchored at ultra-low levels, pushing investors to take on more risk in their search for yield and put some of their money into the euro zone's lower ranked bonds.

Spanish 10-year yields were steady around 3.51 percent, a tad higher than an eight-year low of 3.49 percent hit on Thursday. Italian yields inched lower to 3.47 percent and a fall below 3.43 percent would take them to their lowest since October 2005.

"The market is quite focused on the deflation topic," said Marius Daheim, chief strategist at Bayerische Landesbank. "A slight reduction in inflation will twist the odds for the ECB to do something at the next meeting."

German 10-year Bund yields, the benchmark for euro zone borrowing costs, were up 0.7 basis points to 1.574 percent, staying within a whisker of 2014 lows of 1.507 percent hit earlier this month.

Bunds, perceived to be among the safest assets in the world, have also found support in geopolitical tensions in Ukraine. Armed men stormed the local parliament on Thursday and others seized an airport in the mainly ethnic Russian region of Crimea, the last big bastion of opposition to the new leadership in Kiev since pro-Russian Viktor Yanukovich was ousted at the weekend.

"THE BIG STORY IN TOWN"

Data on Thursday showed German annual inflation falling to its lowest levels in 3-1/2 years at 1 percent in February from 1.2 percent in January and compared with a Reuters poll of 1.1 percent. On Friday, data showed Spanish annual inflation at zero, versus expectations of 0.1 percent

The regional inflation data is due at 1000 GMT.

ECB President Mario Draghi said on Thursday the euro zone was not experiencing deflation, but the ECB was alert and will act if needed.

"Draghi was vaguely dovish, sending hints of reacting to deflation," one trader said.

"Inflation is the big story in town in Europe and is enough to keep (euro zone bonds) underpinned."

The forward overnight euro zone bank-to-bank borrowing rates market, one of the best barometers for the perceived ECB outlook, suggests the market attaches a slight chance of easing for the March meeting. The probability increases significantly in coming months, however.

The Eonia rate dated for the March meeting stood at 0.136 percent, slightly lower than the 0.162 percent spot rate. Eonia rates dated from May onwards are 0.10 percent or lower.

"The inversion of the Eonia curve ... suggests the market is pricing in some ECB action in the next few months, albeit only a low probability is priced for the meeting in March," Barclays strategists said in a note.

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