August 28, 2014 / 11:25 AM / 3 years ago

Bund yields hit new low on Ukraine crisis, periphery yields rise

* Ukraine president says Russian troops have crossed border
    * Spanish August inflation at -0.5 pct vs -0.6 pct fcast
    * Euro zone inflation data due on Friday
    * Italy sells 8 bln euros of debt at record low yields

 (Updates with Italian action)
    By Marius Zaharia
    LONDON, Aug 28 (Reuters) - German Bund yields hit a record
low after Ukraine accused Russia of moving troops across the
countries' border, while lower-rated euro zone bond yields rose
after above-forecast inflation readings tempered expectations of
imminent ECB easing.
    Ukrainian President Petro Poroshenko said on Thursday
Russian troops had entered Ukraine, and said his security and
defence council would meet to decide how to respond.
 
    Bunds, which perform well in times of heightened uncertainty
because they are seen as ultra-safe assets, saw their 10-year
yields hit a new low of 0.89 percent.
 
    Peripheral euro zone bond yields suffered after inflation
data from Spain and some of the German regions pointed
to a higher-than-expected number for the whole euro zone. 
    Inflation across the currency union was previously expected
to fall to 0.3 percent in August from 0.4 percent in July. It is
now expected to be at least stable, though still far below the
European Central Bank's target of just below 2 percent.
    The data is due on Friday.
    "Slightly better than expected inflation data could probably
delay expectations of QE and this is why the periphery is
underperforming, while the latest headlines in Ukraine triggered
a rally in core markets," said Patrick Jacq, a rate strategist
at BNP Paribas in Paris.
    Speculation that the ECB was getting close to announcing a
large-scale asset purchase programme, known as quantitative
easing (QE), grew after President Mario Draghi highlighted in a
speech on Friday a "significant" fall in inflation expectations.
    ECB sources said the central bank was unlikely to take new
policy action next week unless August inflation figures showed
the euro zone sinking significantly towards deflation.
 link.reuters.com/fug72w
    Spanish and Italian 10-year yields
 rose 8 basis points to 2.22 percent and 2.45
percent, respectively.
    
        
    INFLATION EXPECTATIONS
    The five-year, five-year forward breakeven rate
 - the ECB's preferred measure of what the market
thinks the inflation outlook is - has picked up since Draghi's
speech on Friday in Jackson Hole, Wyoming.
    The rate, which now shows roughly where investors expect
forecasts of inflation for 2024 to be in 2019, had fallen by
roughly 20 bps in less than a month before those remarks and was
approaching its 2010 record lows of around 1.90 percent. It has
since picked up to a shade above 2 percent.
    Other measures still show very low long-term inflation
expectations. Ten-year inflation swaps stand at
1.5 percent, while five-year swaps trade at 1 percent.
    Two-year German breakeven rates, derived from the yield gap
between conventional and inflation-linked bonds, are negative.
Ten-year breakeven rates at 1.26 percent are not far from
Japan's 1.18 percent. Japan has battled low growth and deflation
for most of the past 20 years.
    Spanish inflation, although higher than expected, fell in
August to minus 0.5 percent.
    "There are two scenarios. We're either indeed going towards
a climate like that of Japan ... or we are in a massive bond
bubble which at some point of course it will burst," said KBC
strategist Piet Lammens.
    Low inflation or deflation may create problems for the euro
zone's lowest-rated economies' efforts to cut their debts.
However, prospects of QE make those bonds attractive at this
stage as the market sees the ECB as a likely heavy buyer at any
price.
    This ensured Italy was able to sell 8 billion euros of five-
and 10-year bonds at record low yields. 

 (Graphics by Vincent Flasseur, editing by Nigel Stephenson and
John Stonestreet)

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