UPDATE 2-Bunds rise as ECB outlook offsets prospect of UK rate rise

Fri Jun 13, 2014 12:24pm 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 (Updates prices, adds fresh comments)

By John Geddie

LONDON, June 13 (Reuters) - German bonds recovered after an earlier fall on Friday, as investors shrugged off worries that a rate increase 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, dropped as much as 43 ticks at Friday's open after Bank of England Governor Mark Carney said UK interest rates might rise sooner than markets expect. But towards the close of business in Europe, they had risen to 145.55, 30 ticks up on the day.

Strategists said data confirming the euro zone's alarmingly weak inflation served as a reminder that the paths of ECB and Bank of England policy had completely diverged.

"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.

Worries over low inflation in the euro zone had centered on the bloc's fragile peripheral states, but one of its strongest credits was the 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 analyst forecasts for an uptick.

While the ECB has cut rates to 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 an 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 were 2 basis points down on the day at 1.4 percent, having risen slightly earlier. 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 increased demand for safe-haven German paper but did not seem to curb 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 4 bps to 2.67 and 2.79 percent respectively.

"(ECB chief Mario) Draghi has provided the opportunity for spreads to move even lower, which is good news for peripheral economies as borrowing costs for governments come down even more," said Chris Iggo, chief investment officer for fixed income at AXA Invstment Managers. "Ten-year bond spreads of below 100 bps (over Bunds) for both Spain and Italy look achievable now."

Italian and Spanish yield gaps over Bunds are now at 142 and 130 bps respectively.

NEW LOWS

In money markets, the overnight bank-to-bank Eonia lending rate 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 keeping short-term rates low.

Liquidity will get 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 room for money rates to fall in months ahead.

Hopes for a full-blown programme of government bond purchases by 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. (Additional reporting by Emelia Sithole-Matarise; Editing by Larry King)

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