* Two-year yields rise to near 10-month highs before retreat
* Coeure plays down market-effect of ECB loan repayments
* U.S. debt limit concerns support Bunds
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Jan 18 (Reuters) - German two-year bond yields retreated from near 10-month highs on Friday after an ECB board member cooled some of the market’s fears over early bank repayments of long-term central bank loans.
Shorter-dated bonds were the main beneficiary of the ECB’s 1 trillion euro in loans to euro zone banks in late 2011 and early 2012 and, along with record-low official interest rates, drove German two-year yields into negative territory.
The prospect that some of the cash might be withdrawn from the market as banks start to repay back the loans pushed German two-year yields to as high as 0.25 percent on Friday, the highest since the end of March 2012.
But the yields retreated after policymaker Benoit Coeure said he did not expect the payments to have any significant impact on short-term rates. They last stood at 0.185 percent, down 1.2 basis points on the day.
Analysts said the recent spike in yields was due to fears that an improvement in sentiment towards the euro zone’s lower-rated issuers may prompt banks to pay back their loans en masse. But with the euro zone economy still weak, those fears may be overdone, analysts said.
“There has been a bit of a panic. The market was worried about how much (money) banks are going to pay back to the ECB,” said Vincent Chaigneau, head of interest rate strategy at Societe Generale.
“Fundamentally, the move is excessive. Maybe Coeure has calmed the markets a little bit, but we have to wait and see.”
He recommended clients to bet against a rise in short-term rates, saying that for repayments to have an impact on the market, the excess liquidity should fall by two thirds from the current level of 630 billion euros - an unlikely scenario.
Banks can start making repayments from the end of January. Suggestions they may also have to provide more detail on the collateral they exchange for cash at the ECB, which could ultimately restrict their use of the cheap loans, added to the jitters.
To avoid volatility in shorter-dated core euro zone debt, Credit Agricole rate strategist Peter Chatwell suggests a so-called flattener trade which would favour longer-dated bonds in that market.
Further up the German curve, cash 10-year Bund yields were 5.2 bps lower on the day at 1.493 percent.
Longer-dated German debt followed the lead from the front-end of the curve, but 10-year yields were already lower before Coeure’s comments.
Concerns over a debate on raising the debt ceiling in the United States prompted investors to buy back the Bund, which was cheapened earlier this week by solid auctions of higher-yielding Spanish and Italian debt this week.
But if demand for Spanish and Italian debt continues to improve, Bunds are unlikely to sustain their recovery, analysts said.
“A number of people still have these long positions in Bunds. With the easing of risks in the euro zone, there’s still so much cash in safe havens which might still go into higher yielding assets,” said Piet Lammens, a strategist at KBC.
Bund futures were last 60 ticks up at 143.36.