CORRECTED-Euro zone peripheral bond yields near multi-yr lows before inflation data

Mon Mar 31, 2014 3:36am EDT

(Corrects bank's name in paragraph 8 to Credit Agricole, not Luca Jellinek)

By Marius Zaharia

LONDON, March 31 (Reuters) - Lower-rated euro zone bond yields held near multi-year lows on Monday, with an expected drop in euro zone inflation keeping speculation rife that the European Central Bank may loosen monetary policy further later this year.

Economists in a Reuters poll predicted a drop in inflation to 0.6 percent in March from 0.7 percent the previous week, but below-forecast Spanish and German inflation data on Friday raised expectations of an even smaller figure. The euro zone inflation figure is due for release at 0900 GMT.

The ECB is not expected to cut interest rates at its meeting on Thursday, a Reuters poll showed. But an inverted money market curve points to some expectation that it could eventually ease monetary policy.

Even if the ECB does not ease policy, it is likely that it will keep rates at record lows for a long time to bring inflation back towards its target of just below 2 percent.

That would keep yields on top-rated euro zone debt at ultra-low levels, pushing investors towards lower-rated bonds as they try to maximise returns.

Italian 10-year yields dipped 1.5 basis points to 3.29 percent on the day, having hit an 8-1/2 year low of 3.261 percent on Friday. Spanish yields fell 1 bps to 3.23 percent, just off an eight-year low of 3.20 percent.

Portuguese yields were flat at 4.05 percent, having dipped below 4 percent for the first time in four years on Friday. Irish yields were only 2 bps off their record lows of 2.974 percent.

"The EGB (European government bonds) market is fairly overbought but should be boosted further by a weak ... (inflation) figure," said Luca Jellinek, European head of fixed income at Credit Agricole.

Most of last week's rally in peripheral bonds was driven by comments by ECB policymaker and Bundesbank chief Jens Weidmann that 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.

But on Saturday, Weidmann said the euro zone was not in a deflationary cycle and that the ECB should not overreact to a slowdown in inflation which should prove temporary.

"Weidmann is playing down deflation so I would have thought we'd open much lower (in prices). But it's also month-end," one trader said. (Reporting by Marius Zaharia; Editing by Hugh Lawson)

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