Euro zone bonds flip-flop as inflation clouds ECB easing bets

Tue Apr 29, 2014 10:01am EDT

* Subdued German inflation keeps QE hopes alive
    * Draghi tells German lawmakers QE some way off
    * Rise in Eonia rates triggers talk of ECB rate cut
    * Banks increase take-up at weekly ECB weekly cash offer

 (Recasts and writes through)
    By Marius Zaharia and John Geddie
    LONDON, April 29 (Reuters) - Euro zone bond yields
flip-flopped on Tuesday after a below-forecast rise in German
inflation left markets guessing how and when the European
Central Bank may loosen monetary policy.
    German annual inflation rose at a slower pace than expected
in April, keeping speculation rife that the ECB might be forced
to intervene. However, immediate pressure stemming from money
market tension eased after 100 billion euros was injected into
the euro zone banking system. 
    ECB chief Mario Draghi told lawmakers from Germany's ruling
coalition on Monday that an asset purchase programme, designed
to tackle low inflation and curb the strength of the euro, was
still some way off, according to a source who took part in the
meeting.
    Looking ahead to Wednesday's release of euro area inflation,
some market participants said subdued consumer price growth -
which was 0.5 percent last month, and remains far below the
ECB's target of just under 2 percent - may force his hand.
    "(German inflation) is strong indication that euro zone
inflation won't be much higher, providing more tailwinds for
speculation around quantitative easing (asset purchases) in the
coming days," said Felix Herrmann, a market strategist at DZ
Bank.
    German 10-year Bund yields, the benchmark for
euro zone borrowing costs, rose 3 basis points to a day's high
of 1.54 percent before the inflation release, but pulled back to
1.51 percent shortly after.
    Spanish and Italian yields were
also around 3bp higher on the day at 3.10 percent and 3.17
percent, respectively, before paring those losses.
    
    TENSIONS SUBSIDE
    Money market tensions - that are putting added pressure on
the ECB to ease - could soon subside, however. 
    Concerns that the dwindling amounts of spare cash in the
euro zone's banking system could keep money market rates
elevated relaxed after banks took the most in one-week loans
from the central bank since the last week of June 2012.
 
    The 172.6 billion euro take-up from banks at the ECB's
weekly tender compares with last week's 121.8 billion euros,
resulting in a more than 50 billion euro cash injection into the
euro zone banking sector for next week.
    Another 62 billion euros can be added to that after the ECB
opted not to drain an amount equal to its current holdings of
government bonds purchased via its Security Markets Programme at
the height of the crisis. 
    That weekly sterilisation operation was introduced to dampen
fears that the SMP programme was a way of directly financing
governments, something the ECB is not allowed to do. 
    This injection of more than 100 billion euros comes as
pressure has grown for the ECB to tackle a rise in money market
rates caused by a drop in the level of spare cash in the system
to as little as 86.6 billion euros, its lowest since 2001.
    Overnight bank-to-bank Eonia borrowing costs rose
to 0.398 percent on Monday, the highest Eonia rate since 2011
with the exception of two liquidity-tight days at the end of
last year and at the end of the first quarter of 2014.
    Central banks would prefer overnight rates to trade within
the band formed by their key deposit and refinancing rates - now
at 0-0.25 percent in the euro zone. When rates step outside that
corridor, monetary policy becomes less effective. 
    Draghi said earlier this year an "unwarranted" rise in money
market rates would be a trigger for further monetary policy
easing along with a worsening of the inflation outlook.
    "The liquidity injection will move (Eonia) back below the
refi rate in coming days," said FXPRo chief economist Simon
Smith. "Thereafter it will depend on what happens at (the next)
weekly operations."

 (Reporting by Marius Zaharia and John Geddie; Editing by Alison
Williams)
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