* Two-year yields rise to near 10-month highs before retreat
* Bund futures edge up on U.S. debt limit concerns
* Spanish, Italian bonds steady after auctions this week
By Emelia Sithole-Matarise
LONDON, Jan 18 (Reuters) - German two-year bond yields rose to their highest in nearly 10 months on Friday with further falls likely on growing nervousness in money markets over early bank repayments of three-year European 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The prospect that some of that cash might be withdrawn from the market as banks start to repay back the loans pushed short-term money market rates to their highest since July on Thursday.
German two-year bonds yielded as much as a quarter percentage point early on Friday, extending Thursday’s sell-off , before retreating to trade flat on the day at 20 basis points as some traders bought back into the cheapened market.
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.
“ECB excess liquidity is a strong driver of front end rates in particular so if liquidity increases front end rates fall. The market is now working on the assumption that liquidity is going to reduce significantly so rates are under pressure to rise,” said Credit Agricole rate strategist Peter Chatwell.
With no hard data yet available on the repayments, Chatwell said the two-year yield could stabilise around 0.20 percent but a break lower could not be ruled out.
“Unless we close below this in yield terms then that will be established as a resistance for the market...Sellers will be looking to sell at 0.20 percent to try and hit some higher yield targets,” he said.
To avoid volatility in shorter-dated core euro zone debt, Chatwell suggests a so-called flattener trade which would favour longer-dated bonds in that market.
Some traders, however, said the sell-off looked overdone given that the ECB was still expected to cut interest rates some time in the coming months. Two-year yields are particularly sensitive to shifts in expectations on monetary policy.
“We’ve hit some interesting levels. Schatz above 20 basis points haven’t been there since early-to-mid last year,” one trader said. “We don’t have an ECB rate cut in the imminent future but a rate cut is more likely than a rate hike, which is why I believe the front end is oversold.”
Further up the German curve, cash 10-year Bund yields were 1.3 bps lower on the day at 1.53 percent as some investors bought back bonds which fell in price after solid auctions of higher-yielding Spanish and Italian debt this week.
Concern there could be a standoff over the U.S. debt limit helped Bunds claw back ground after Thursday’s sharp sell-off, though an improvement in demand for riskier assets posed risks to any significant recovery.
“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 10 ticks up at 142.86 though charts pointed to further weakness.
“A weekly close below 143.00 will see the 2011-2013 uptrend severed and imply that the market has in fact topped. Beyond the 55-week moving average at 141.61 we look for losses initially to the 138.41 September 2012 low,” Commerzbank analysts said in a note.
Spanish and Italian 10-year yields held at 5.12 and 4.17 percent respectively, with some in the market saying their recent rally may be due a correction.