June 6, 2018 / 11:23 AM / 2 months ago

UPDATE 4-Bond markets spooked as ECB set to debate stimulus exit next week

* ECB’s Praet catches markets off guard with inflation comment

* Italian bonds suffer as investors eye aggressive fiscal plans

* Trading volumes rise on Italian bonds

* U.S. Treasury yields rise to near 2-week highs (Adds Italian CDS move, updates prices)

By Saikat Chatterjee and Dhara Ranasinghe

LONDON, June 6 (Reuters) - Germany’s bond yields were set for their biggest daily jump in nearly a year on Wednesday, with borrowing costs across the euro zone rising on concerns the European Central Bank could signal its desire to wind down massive stimulus as early as next week.

The impact was felt deepest in Italy where bond investors have also been grappling with the prospects of likely aggressive borrowing by a new government.

ECB chief economist Peter Praet said on Wednesday the central bank was increasingly confident that inflation is rising back to its target and will next week debate whether to gradually unwind bond purchases.

The remarks, which come just a week ahead of a closely-watched ECB meeting, caught markets off guard so much so that German 10-year bond yields have retraced most of the falls seen last week when Italian concerns peaked.

Some investors had bet the ECB would adopt a more cautious tone.

“Praet, who is generally considered a dove by bond markets, has shifted the risks for an ECB policy unwind and next week potentially becomes a live one,” said Orlando Green, European fixed income strategist at Credit Agricole in London.

Ten-year German bond yields rose over nine basis points to 0.46 percent, on track for their biggest daily rise since late June 2017. With the exception of Italy, most euro zone bond yields were 6-10 bps higher on the day across the bloc.

The euro also rose after Praet’s comments, hitting a 10-day high against the dollar.

Money markets have now fully priced in a 10 basis point rate hike from the ECB by July next year. Last week, amid the Italy turmoil, a hike was not fully priced in until October 2019.

ITALY SUFFERS

Italian bonds once again stood out as the underperformer as the new government showed no desire to tone down its big-spending plans for the euro zone’s third-biggest economy.

Ten-year bond yields jumped 20 basis points to 2.96 percent before settling at 2.93 percent, while short-dated bond yields were up 36 bps at 1.35 percent.

The average daily change in basis points over the last seven sessions for 2-year Italian bonds has been 65 bps, according to Deutsche Bank.

Italian five-year credit default swaps (CDS) jumped by 22 basis points (bps) from Tuesday’s close to 231 bps - their highest level in nearly a week, according to data from IHS Markit.

Though Italian bond yields remained well below their peak last week, analysts said a combination of a hawkish ECB and a likely fiscally profligate Italian government would keep upward pressure alive on peripheral debt.

“It is a signal that if we get tighter policy it is these countries that will suffer more than Germany,” said Jan von Gerich, chief strategist at Nordea.

Trading has picked up this week with trading volumes on Tuesday at 292,872 contracts for the 10-year Italian bond futures, exceeding last week and at its highest in three weeks.

UBS analysts estimate the ambitious fiscal spending plans of Italy’s new government would blow out its fiscal deficit to 4.4 of GDP, versus 2.3 percent in 2017. They would also push its primary surplus from 1.9 percent of GDP to well into negative territory at minus 3.9 percent by 2020.

Reporting by Saikat Chatterjee, Dhara Ranasinghe and Sujata Rao; Editing by Jon Boyle and Elaine Hardcastle

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