Diverging Fed, ECB outlooks hoist U.S-German spread to 15-month high

Wed Mar 26, 2014 8:25am EDT

* U.S. 2-year yield premium over Germany at 15-month peak

* Dovish ECB remarks spur German debt outperformance vs U.S

* Rest of euro zone bonds also rallying (Recasts with moves in U.S./German yield spread, adds detail)

By Emelia Sithole-Matarise

LONDON, March 26 (Reuters) - The U.S. two-year bond yield premium over Germany hit a 15-month high on Wednesday as European Central Bank policymakers' hints at radical stimulus measures while the Federal Reserve mulls tighter policy fueled Bunds' outperformance.

Euro zone bond yields have reversed the rise seen last week after Fed Chair Janet Yellen jolted financial markets by signalling the bank might hike interest rates sooner than many were expecting after it phases out its bond purchases.

The rebound gained momentum this week as some of the ECB's more conservative policymakers said the bank could adopt more unconventional measures to tackle a surging euro and ward off deflation.

ECB governing council member and Bundesbank chief Jens Weidmann said negative interest rates were an option to temper euro strength and buying loans and other assets from banks to support the bloc was not out of the question.

This marked a softening of stance from one of the most hawkish ECB policymakers who has previously opposed such extraordinary measures.

The stepped-up ECB rhetoric highlighted the divergent outlooks for monetary policy between the euro zone and the U.S. hoisting the two-year U.S. bond yield premium over Germany to its highest since mid-December 2012 at 31 basis points.

The 10-year Treasury note/Bund gap is also at its widest since mid-2006 as data on Tuesday showed U.S. confidence hit a six-year high in March, suggesting the world's biggest economy was gaining momentum after being held back by severe weather.

"There's certainly scope for the spread to widen further given the fact that ECB policymakers are speaking in a very dovish tone which supports the front end of the curve in Europe while there's justification for Treasury yields to go higher," said Orlando Green, a strategist at Credit Agricole.

The two-year U.S./German bond yield spread could expand to as much as 50 bps in coming weeks, a level last seen in mid-2007 just before the financial crisis broke out, Green said.

German 10-year Bund yields dipped 1 basis point to 1.57 percent and have fallen nearly 10 bps from two-week highs hit last week following Yellen's comments.

RESILIENT PERIPHERY

Yields on other top-rated euro zone bonds were 2 bps lower while Spanish and Italian 10-year yields were 4 bps down at 3.29 percent and 3.36 percent respectively.

Market anticipation of more ECB policy easing was supporting flows into peripheral euro zone bonds which offered higher returns than safe haven Bunds.

The fall in Italian yields before a sale of 10 billion euros of longer-term bonds on Friday underlined the strong investor appetite for debt from the region's weaker issuers.

Normally, yields rise before auctions as investors make way in their portfolios for the new bonds.

"There's plenty of investor appetite for peripheral bonds and the auctions will go well. With the ECB maintaining an easing bias and the euro area economy gradually improving there's scope for further outperformance of peripherals relative to Bunds going forward," said Nick Stamenkovic, a strategist at RIA Capital Markets in Edinburgh.

The ECB's next policy meting is next week. Market focus is now largely on German inflation data due on Friday.

If this points to euro zone inflation remaining very subdued, it could increase pressure on the ECB to act sooner rather than later.

But despite Weidmann's comments, some said they still saw ECB asset purchases to support the economy as a last resort.

"Mr. Weidmann's comments yesterday were superficially positive about QE. They have not changed our view that QE is an absolute last resort - rather we view the comment as an indication that easier ECB policy remains on the table," RBS strategists said in a note. (Editing by Sophie Hares)

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