Bund yields slide to record lows as ECB warns of Ukraine shock

Thu Aug 7, 2014 12:08pm EDT

* Russia plans to ban food imports from U.S., Europe

* Risks to European economy give ECB new headache

* German 10-year yields hit new lows while periphery suffers

* Greek bond sell-off halts after reform bill passed (Adds quote, updates prices)

By Marius Zaharia and John Geddie

LONDON, Aug 7 (Reuters) - German Bund yields dropped to a record low on Thursday as the European Central Bank warned that the Ukrainian crisis and tit-for-tat sanctions with Russia may threaten Europe's already fragile economic recovery.

Russia will ban all imports of food from the United States and all fruit and vegetables from Europe, the state news agency said on Wednesday. Russia is by far the biggest buyer of European fruit and vegetables.

The announcement came as fighting intensified on the ground in eastern Ukraine between Kiev's government forces and pro-Russian separatists. Russia has massed around 20,000 combat-ready troops on Ukraine's border, according to NATO, who on Thursday called on Moscow to "step back from the brink".

At the ECB's monthly policy meeting - where it left its main interest rates unchanged - President Mario Draghi cited the tension between Russia and the West over Ukraine among the threats to growth in the euro zone.

"Tensions in Ukraine are escalating and this is the key area to watch in the next few months. The German data very much highlights the risks," Berenberg economist Holger Schmieding said.

In the latest signal that Europe's largest economy may have stalled in the second quarter, German industrial output rose just 0.3 percent on the month in June, missing a forecast rise of 1.3 percent.

The disappointing data did little to prevent investors from flocking to the safe haven of German bonds, however, while riskier assets sold off.

Ten-year Bund yields dropped 3 basis points to a new record low of 1.07 percent.

SPAIN AUCTION

Portuguese and Italian 10-year bond yields edged up 5 bps to 3.87 and 2.85 percent, respectively. The Spanish equivalents edged up 3 bps to 2.61 percent.

Spanish bonds were seen outperforming their peers after a strong auction earlier in the day.

Madrid sold 3.1 billion euros of six- and 10-year bonds, more than targeted, drawing strong demand. Traders said some investors had used the auction as an opportunity to replace Italian with Spanish bonds, after data on Wednesday showed Italy had slipped back into recession.

Other analysts were less worried about Italy.

"While the recent slowing down in growth momentum for Italy needs to be monitored, we continue to see ECB monetary policy as an important factor that should keep credit spread compression going," said Luca Cazzulani, rate strategist at UniCredit.

Spain has performed above expectations so far this year and is expected to grow about 1.5 percent in 2014.

Sandra Holdsworth, investment manager at Kames Capital, remained cautious on debt from the euro zone periphery.

"For peripheral countries, a slowdown in the pace of the European recovery from these levels can create problems," said Holdsworth, whose group manages assets worth about $63 billion.

Greek bonds - which have suffered this week on fears that the country may be resisting reforms just as the EU considers easing up on supervision - appeared more resilient on Thursday, with 10-year yields dipping 4 bps to 6.52 percent.

Strategists said investors welcomed news late on Wednesday that Greek lawmakers had passed a series of reforms. That paves the way for its next bailout payment, and investors are starting to see value in the bonds after the recent sell-off, they said. (Reporting by Marius Zaharia and John Geddie; Editing by Larry King)

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