* Greek CDS, spreads widen after Moody’s downgrade
* Portuguese yields at new highs ahead of supply
* Bunds lower in thin trade; oil prices watched
* Curve steepens, but seen as short-lived move
By Kirsten Donovan
LONDON, March 7 (Reuters) - Greek and Portuguese government bond yields rose on Monday after Moody’s slashed Athens’ credit rating, with the latter reaching new euro lifetime highs ahead of a debt sale later this week.
Moody’s cut Greece’s credit rating three notches to B1, deep into “junk” territory and highlighted the risks the country might have to restructure its debt.
Greek bonds underperformed German benchmark debt, increasing the 10-year yield spread by 7 basis points to 917 bps.
Portuguese bonds were caught in the backlash, with both 2- and 10-year yields PT2YT=TWEBPT10YT=TWEB reaching new euro lifetime highs of 6.24 percent and 7.65 percent respectively.
“It’s a combination of supply on Wednesday...and the rating downgrades of Greece and Spain on Friday probably have not helped the tone,” a trader said.
“It’s very very thin but we are getting to levels that it’s fairly serious.”
Portugal is seen as the next most likely candidate for a bailout with funding at current yield levels an unsustainable prospect and with its bonds under pressure anyway ahead of a 2-year bond sale on Wednesday.
Greece led a rise in five-year credit default swaps in peripheral Europe, with a 52 basis point increase on the day to 1,035 bps, according to Markit.
“The stressed selling of Greece continues,” another trader said. “The very long end of the Greek curve prices in a significant haircut at this stage, but there is still room for the five- and the 10-year to move towards that.”
A change in Spain’s rating outlook to negative by rating agency Fitch drew less reaction in the bond market because it merely brought the agency into line with its competitors.
Markets are scrutinising any comments from euro zone leaders in the run-up to their meeting on Friday to discuss possible solutions to the bloc’s debt crisis.
March Bund futures FGBLc1 settled 12 ticks down at 123.03, with June futures FGBLM1, which become the front month on Tuesday — down 10 ticks at 121.64.
The yield curve steepened with 10-year German Bund yields DE10YT=TWEB half a basis point higher at 3.389 percent and two-year yields DE2YT=TWEB down 1.1 bps at 1.759 percent.
“The bear steepening that we have seen today, along with the spread widening in Greece and Portugal, is an indication the market is pricing in some credibility transfer going into the important EU meetings this month,” said Norbert Aul, rate strategist at RBC Capital Markets.
Bunds were under pressure for most of the session not only from the periphery but also as oil prices CLc1 eased from 30-month highs hit as conflict in Libya threatenedd to escalate into civil war, giving a bid to riskier assets such as equities [ID:nLDE7260G5].
Bund prices often fall as oil prices rise on fears of inflation and signs of economic growth, but the relationship has shifted in recent weeks with futures prices showing their strongest positive correlation (over a 30-day period) in almost two decades, according to Reuters data.
Markets are also shifting focus back from safe haven flows to the risk of official efforts to tame inflation after the European Central Bank surprised last week by signalling it could hike interest rates as soon as April.
That is likely to fuel further flattening pressure in the German 2/10-year curve, despite an outperformance of the two-year Schatz note on Monday due to a profit taking and the underperformance of longer-dated paper.
“Going forward, the ECB should have the bigger impact...the flattening pressure from monetary policy should be more pronounced although a lot depends on how the EU summits turn out,” RBC’s Aul said.
Analysts have suggested using any steepening moves to reset bets that the curve will flatten.
Editing by Ron Askew