Zero-yielding German two-year bonds meet strong demand

Wed Aug 20, 2014 12:10pm EDT

* Investors bid for twice the amount at German auction

* Markets attach higher probability of ECB QE

* Bund premium over Treasuries near historic highs

* Overnight Eonia hits another record low (Adds comment, updates prices)

By Marius Zaharia and John Geddie

LONDON, Aug 20 (Reuters) - German two-year debt yields held close to 15-month lows just below zero on Wednesday, with record low money market rates and expectations of easier ECB monetary policy underpinning demand at an auction of similarly dated bonds.

Germany sold over 4 billion euros of a new two-year bond, with demand from investors double that amount despite the average yield and the coupon both being zero.

Data last week showing the euro zone economy stagnated in the second quarter even before the impact of sanctions imposed on and by Russia over the conflict in Ukraine cemented expectations European Central Bank interest rates would stay ultra-low for a long time.

It has also rekindled expectations the ECB could eventually print money to buy debt, or in market jargon, do quantitative easing (QE). A Reuters poll this week showed money market traders saw a 50-percent probability of QE in the next 12 months, up from a one-in-three chance in last week's survey.

"We've seen really bad growth numbers and these translate into deflation fears, which in turn fuel QE expectations," DZ Bank market strategist Felix Herrmann said, noting that risks around wars in Iraq, Ukraine and Gaza also supported demand at the German auction.

"All that argues for lower German yields for shorter and medium term maturities. There are few, if any, reasons for Bund yields to rise."

Two-year bonds yield minus 0.004 percent in the secondary market, meaning buyers will get slightly less money than they invested when the bond comes due. They first traded negative at the height of the euro zone debt crisis in 2012.

Some banks may prefer to buy such assets rather than being charged 10 basis points for keeping the money in the ECB's deposit facility - a result of the central bank's unprecedented deposit rate cut into negative territory in June.

That rate cut and the ample excess liquidity in the euro zone banking system has pushed the overnight bank-to-bank Eonia lending rate fell to a new record low of 0.005 percent.

"This is a combination of expectations of very low rates for a very long period of time but also a reflection that the market has raised the odds of the ECB being drawn into taking more serious action," Rabobank senior market economist Elwin de Groot said.

DIVERGING RATES

Any further loosening of monetary policy from the ECB is likely to come around the time the U.S. Federal Reserve starts to raise interest rates in support of a rebounding U.S. economy. This diversion in policy is likely to further accentuate the widening of the spread between German and U.S. bond yields.

In the two-year sector, German bonds offer about a 45 bps premium to their U.S. equivalents, just below the widest premiums in seven years, hit late last month.

"The way that the fundamentals are diverging and the rhetoric of the central banks are diverging it sustains this widening move, no question," Credit Agricole's European head of fixed income Luca Jellinek said.

Market participants will pour over the minutes from the U.S. Federal Open Market Committee's latest meeting, due to be released at 1800 GMT on Wednesday, looking for hints of when exactly the Fed may make hike rates.

Elsewhere in the euro zone, ECB easing expectations pushed other euro zone yields lower on Wednesday. Spanish and Italian 10-year yields hit new record lows earlier in the session, falling 6 and 3 bps respectively to 2.38 and 2.56 percent, before reversing some of those gains in the afternoon.

Portuguese and Greek equivalents dropped 12 and 10 bps respectively to two-month lows of 3.31 and 5.80 percent. PT10YT-TWEB (Editing by Louise Ireland)

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