* German debt prices stable after steep selloff on Friday
* ECB loan repayments set to drive short-term yields higher
* Rise seen gradual as demand for safe havens persists
By William James
LONDON, Jan 28 (Reuters) - German yields were steady on Monday but looked set to creep higher over the medium term as banks repay emergency loans from the European Central Bank early and drive up money market rates.
The ECB announced on Friday that 137 billion euros of three-year banking sector loans would be repaid early.
That amount exceeded expectations and was taken as a sign that areas of the banking system were recovering and that money market rates would rise. It dented safe-haven demand for long-term German debt and caused a selloff in short-dated bonds.
The move slowed on Monday with Bund futures trimming an early fall to trade 13 ticks lower at 142.37 while two-year German yields were half a basis point higher at 0.264 percent after an 8 basis point rise on Friday.
Traders said the slowdown in the selloff in thin early trade was natural given the large scale of Friday’s moves, with some cautious investors attracted back into the market at cheapened levels.
Longer-term, though, the prospect of excess cash draining from the system was due to keep upward pressure on German bond yields, with banks now having the opportunity to repay cash on a weekly basis.
In theory, the less surplus cash in the system, the more banks have to compete to secure funds, driving short-term rates higher, generating a knock-on effect into bond markets.
“We will continue to see a selloff in the market. This should be driven from the front end due to the fact that we see liquidity moving away from the market and pushing two-year yields higher,” said ING rate strategist Alessandro Giansanti.
He said two-year yields could rise as high as 0.4 percent as market conditions normalise over the coming months, with the impact on the longer-end of the curve smaller at around 10 basis points. Ten-year yields were last at 1.59 percent.
Focus will now turn to weekly repayments to see if banks continue returning the cash and particularly on Feb. 27, which for the first time will include repayments from the second of two long-term borrowing operations held in December 2011 and February 2012.
After Friday’s initial adjustment, moves were expected to be much slower over coming sessions, with plenty in the market who believe the risks remaining in the euro zone still warrant investment in safe haven assets.
“I wouldn’t fight this trend for now but my feeling is that the market is over-reacting a little,” said Elwin de Groot, strategist at Rabobank in Utrecht.
“There’s still a lot of uncertainty regarding the economic recovery in Europe... and there’s some structural problems that don’t solve too easily. We’re still not in a situation where investors are switching out of the Bund safe-haven.”
Later, Italy will kick off a busy week of new debt issuance with a sale of zero-coupon and inflation-linked bonds. Both were expected to find solid demand, in line with investors’ improving appetite for peripheral debt so far this year.