July 25, 2019 / 8:56 AM / 2 months ago

UPDATE 2-Euro zone bond rally grinds to a halt after Draghi doesn't deliver cut

* Investor hopes for easing high before ECB meeting

* Draghi keeps rates on hold, signals more easing

* Bond yields rise after earlier fall to new lows

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Writes through after Draghi news conference)

By Virginia Furness and Saikat Chatterjee

LONDON, July 25 (Reuters) - A strong rally in euro zone bonds ran out of steam on Thursday after European Central Bank policymakers left rates unchanged but opened the door to more easing, underwhelming investors who had expected more.

Core German government bond yields were left higher on the day after a news conference in which ECB President Mario Draghi signalled another round of monetary easing but expressed caution about pulling the trigger too quickly.

Yields across the bloc had fallen sharply, with the German 10-year Bund touching new all-time lows, in the wake of the ECB’s initial statement, which markets interpreted as dovish.

The ECB said in its statement it saw rates at “present or lower levels” through mid-2020, giving up a previous pledge to keep rates unchanged. It also tasked its staff with looking at various other easing options including restarting asset purchases.

But bond markets, which had rallied significantly in the run-up to Thursday’s meeting, expecting immediate action, appeared disappointed by the tone of Draghi’s news conference. Yields were mostly up across the board by around 1300 GMT.

Germany’s government bond yield was 3.5 bps higher at -0.346%, having earlier hit a new all-time low of -0.422% — below the ECB’s -0.4% deposit rate.

“The initial statement put all the options on the table, as well as the potential for tiering, but then he was a bit less forthright,” said Lyn Graham Taylor, rates strategist at Rabobank.

“The message from the press conference was that we haven’t discussed much, and things are mostly pushed back to September.”

Money markets are now pricing in around an 84% chance of a 10 basis point rate cut by the ECB in September.

The increasingly overt promises of more stimulus are intended to prop up confidence in a euro zone economy struggling with a manufacturing recession that risks unravelling years of stimulus by the central bank.

But some commentators believe the ECB is running out of options.

“He’s doing his best to support the euro zone, but we’re reaching the point where they are running out of ammunition and at some point you’ll see questions about credibility,” said Oliver Blackbourn, portfolio manager on the UK-based multi-asset team at Janus Henderson Investors.

“It’s difficult to see what they can do without some sort of fiscal response or joint response between fiscal side and the central bank.”

Italian 10-year government bond yields were last up 5 bps on the day, reversing an earlier drop of 11 basis points to stand at 1.55%.

Other 10-year bond yields in the periphery were around 6 bps higher, having earlier fallen by as many as 9 bps .

Draghi also said the ECB’s all-important inflation target of just under 2% should not be viewed as a cap, opening the door to more stimulus for longer.

A market gauge of long-term inflation expectations rose to its highest level since May 2019 during Draghi’s speech, rising from 1.2957 at Wednesday’s close to a high of 1.3582 before easing back to 1.3269.

The ECB meeting followed more poor economic data.

Business morale in Germany, the euro zone’s biggest economy, deteriorated more than expected in July, hitting its lowest level since April 2013, the monthly Ifo institute survey showed on Thursday.

That followed a flash Purchasing Managers’ Index (PMI) reading on Wednesday showing business growth across the euro zone has been much weaker than expected this month.

Although a majority of economists in a Reuters poll expected a deposit rate cut only in September, weak data had raised pressure on ECB officials and sent German yields deeper into negative territory.

Reporting by Saikat Chatterjee and Virginia Furness; Graphic by Sujata Rao; Editing by Catherine Evans

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