Bunds shrug off UK rates worries to hit day's high

Fri Jun 13, 2014 6:47am EDT

* Bunds recover after shaky open

* Portugal lags peripheral rally

* Eonia dips below Monday's record low

* ECB's Weidmann warns against govt bond buying (Adds fresh comments, updates prices)

By John Geddie

LONDON, June 13 (Reuters) - German bonds recovered after an earlier fall on Friday, as investors shrugged off worries that a rates rise in the UK would have a knock on effect for euro zone government borrowing costs.

Bund futures, the most actively traded securities in euro zone bond markets, initially dropped as much as 43 ticks at Friday's open after Bank of England Governor Mark Carney said UK interest rates could rise sooner than financial markets expect.

However, by mid-morning, Bund futures made a full reversal, climbing to daily highs of 145.63, 37 ticks up on the day.

Strategists said data confirming the euro zone's alarmingly weak inflation served as a reminder that the path of ECB policy had completely diverged from its peer across the channel.

"These deflation pressures show the ECB will keep rates low for a very long time, which is the most important thing for investors," said Christian Lenk, strategist at DZ Bank.

Fears around low inflation in the euro zone have centered on the bloc's fragile peripheral states, but it was one of its strongest credits that was a cause for concern on Friday.

Finland's consumer prices rose just 0.8 percent in May, down from 1.1 percent the previous month. Germany's final inflation reading for May was also left unchanged at just 0.6 percent, despite some analysts predicting an uptick.

While the ECB has cut rates in negative territory in an attempt to stave off deflation and stimulate bank lending, the BoE is gearing up to raise rates to cool its buoyant housing market and support economic recovery.

"The euro area should be a bit immune to UK rates, given the stance of the European Central Bank." said Piet Lammens, strategist at KBC.

German 10-year yields initially opened 1 basis point higher at 1.4 percent, but then reversed to trade lower on the day. The yield spread over equivalent 10-year gilts was also pushed to its widest level since mid-1997.

Bond traders said an escalating civil war in Iraq bolstered investor appetite for safe haven German paper, but it did not appear to dampen risk appetite elsewhere.

Markets appeared to easily digest over 18 billion euros of low-rated bonds sold by Spain, Italy and Portugal on Thursday.

Spanish and Italian 10-year bond yields dropped 1bps lower on Friday, to hit 2.69 and 2.81, respectively, while Greece's dropped 3 bps to 5.73 percent.

Portugal bucked the trend, with 10-year yields rising 1 bps to 3.39 percent, after its finance minister said on Thursday that the country would do without the last payment from its international bailout program after the country's constitutional court rejected a series of austerity measures.

NEW LOWS

In money markets, the overnight bank-to-bank Eonia lending rate EONIA= fixed at 0.043 percent, beating record lows set on Monday before the European Central Bank's negative rate on deposits applied.

The amount of cash euro zone banks have beyond what they need for their day-to-day operations is a key factor holding short-term rates low.

Liquidity will be given a boost next week when the ECB stops withdrawing cash from the banking system to neutralise the effect of the bond purchases it made under the now defunct Securities Markets Programme (SMP).

It has also introduced 400 billion euros of ultra-cheap four-year loans for banks - conditional on their lending to the smaller companies that are Europe's economic backbone - which will be available from September.

With forward Eonia rates dated for November and December showing an implied rate of around 0.03, there is clearly scope for money rates to fall in months ahead.

Hopes for a full-blown programme of government bond purchases from the ECB are more remote, however. Bundesbank chief Jens Weidmann called them "sweet poison for governments" that undermine the central bank's ability to do its job. (Editing by Alexandra Hudson and Toby Chopra)

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