August 28, 2014 / 3:30 PM / 3 years ago

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

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

 (Updates prices)
    By Marius Zaharia
    LONDON, Aug 28 (Reuters) - German Bund yields fell to a
record low after Ukraine accused Russia of moving troops across
their border, while yields on lower-rated euro zone bonds rose
as expectations dwindled that the European Central bank would
loosen policy soon.
    Ukrainian President Petro Poroshenko said on Thursday
Russian troops had entered Ukraine and his security council
would meet to decide how to respond. Moscow says it has no
involvement in the conflict between pro-Russian rebels and the
Ukrainian military. 
    Bunds, which perform well in times of heightened uncertainty
because they are seen as safe assets, saw their 10-year yields
 reach a record low of 0.867 percent.
    Yields on peripheral euro zone bonds suffered after Spanish
deflation data came in better than expected and German
inflation held steady. That led some investors to position for a
surprise in Friday's euro zone inflation report.  
    "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.
    Economists polled by Reuters predict inflation across the
currency union fell to 0.3 percent in August from 0.4 percent in
    Speculation that the ECB was getting close to announcing a
large-scale asset purchase programme, known as quantitative
easing, grew after a speech by President Mario Draghi on Friday
in which he pointed to a "significant" fall in inflation
    But ECB sources said the central bank was unlikely to take
new policy action next week unless August inflation figures
showed the euro zone sinking towards deflation.
    Spanish and Italian 10-year yields
 rose 10 and 7 basis points respectively to 2.24
percent and 2.44 percent, respectively.
    The five-year, five-year forward breakeven rate
 - the ECB's preferred measure of the market's
inflation expectations - 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 deflation reached minus 0.5 percent in August, less
better than expected.
    "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 will burst," said KBC
strategist Piet Lammens.
    Low inflation or deflation may create problems for the euro
zone's lowest-rated economies as those countries try to cut
their debts. However, prospects of QE make those bonds
attractive at this stage, since the market expects the ECB would
be a 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 on

 (Graphics by Vincent Flasseur, editing by Larry King)

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