Peripheral bond yields drop as ECB outlook comes back in focus

LONDON Thu May 22, 2014 3:55am EDT

LONDON May 22 (Reuters) - Yields on the euro zone's lower-rated bonds fell on Thursday after data showed French business activity unexpectedly contracted in May, strengthening the case for more monetary policy easing by the European Central Bank.

Markit's purchasing managers' index for France, covering the manufacturing and services sectors, fell in May to 49.3 from April's 50.6, sinking below the line dividing contraction in activity from expansion.

Germany's PMI met expectations, showing the private sector expanding steadily.

The poor French data reminded investors that the ECB has flagged possible monetary easing actions in June and that it could even start printing money at some point to fight low inflation and boost growth.

The numbers allowed peripheral bond yields to reverse the rise that followed chunky debt sales in Spain and Italy last week and was exacerbated by nervousness about the outcome of European Parliament elections.

"The outlook for monetary policy in Europe is a factor providing a floor for (peripheral) markets," said Elwin de Groot, senior market economist at Rabobank.

Spanish 10-year yields were 5 basis points lower at 2.97 percent, still about 15 bps above record lows hit last week. Italian yields fell 4 bps to 3.17 percent.

Spain plans to issue up to 3.5 billion euros in five- and 10-year bonds later in the day. The amount on offer is smaller than usual, and a back-up in yields from last week's lows should lure in some buyers, ensuring the sale goes well.

But the sale comes on the heels of heavy primary market activity in peripheral markets.

Last week, Spain sold 5 billion euros of inflation-linked bonds and Italy sold 14.25 billion of debt, with some traders saying they felt overloaded with peripheral bonds.

"Today's auctions will ... serve as a good indication of whether last week's periphery supply headache has cleared," Peter Chatwell, rate strategist at Credit Agricole, said in a note.

POLITICAL UNCERTAINTY

Worries the outcome of this week's European parliament elections might destabilise some of the euro zone governments or sway them to delay any painful economic reforms were among the factors behind the recent rise in peripheral yields.

In Greece, a strong showing by anti-bailout parties could hurt the already fragile coalition, potentially paving the way to national elections. In Italy, a weak result for Prime Minister Matteo Renzi's party might weaken his drive for the swift reforms he promised when he took power in a party coup.

BNP Paribas rate strategist Patrick Jacq said the selling pressure was always going to be temporary as long-term investors had not participated.

"Almost no real money account was involved in this selloff in Europe," he said.

The political uncertainty may still make rating agencies cautious when they decide on Friday on the ratings of Greece, Portugal, Spain, France, the Netherlands and the UK.

"The political situation - you have to take that into account as a ratings agency," said de Groot at Rabobank. "It is better to wait for the outcome of EU elections and see if stability is maintained." (Editing by Nigel Stephenson)

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