Euro zone yields head higher after Bank of Japan shift

LONDON, Dec 20 (Reuters) - Euro zone government bond yields rose on Tuesday, echoing weakness in the Japanese market, where yields hit a seven-year high after the central bank surprised investors by loosening some of its strict controls over long-term interest rates.

The Bank of Japan kept broad policy settings unchanged, but widened the allowable band for long-term yields to 50 basis points either side of that, from 25 basis points previously.

Shares dropped and the yen and bond yields spiked following the decision, which investors had not expected to materialise before April, when Governor Haruhiko Kuroda steps down.

Treasury yields rose by as much as 13 bps in Asia, which made for a weaker session in the U.S. and Europe, where German 10-year yields rose 10.5 bps to 2.30%.

Richard Maguire, a senior rates strategist at Rabobank, said there were two ways of looking at the BOJ decision - the first, a "no-brainer" view that it had given up trying to control the yield curve, given rising global inflation and interest rates.

This, at least in theory, would prove a negative for bonds elsewhere, as Japanese fixed income investors repatriated cash in order to tap into higher rates at home, he said.

In practice, the opposite may be true.

"The BOJ has been resolute in standing behind the upper limit of yield curve control. It is clearly a surprising move that they’ve increased the upper band, but you could also argue that maybe they're confident themselves that the peak in interest rates is behind us that pressure isn’t likely to build from here," Maguire said.

If policymakers were less confident that rate expectations and inflation had peaked, the BOJ would be forced into buying even greater volumes of government bonds to keep yields low, and run the risk of losing credibility with markets, he said.

"This leads me to believe that maybe they are of the view that the peak in inflation and rates is behind us and that maybe 0.5% will encourage demand from other overseas investors and that will reduce their imperative to intervene," he added.

Euro zone bonds have already been under intense pressure in the past few months, particularly since last week, when the European Central Bank raised interest rates, as expected, but sounded a far more hawkish note about the outlook for inflation and monetary policy than investors anticipated.

German 10-year yields have risen for five days in a row, as bonds marked their longest stretch of price losses since August.

ECB President Christine Lagarde said the central bank would need to deliver "significant" rate increases at a steady pace.

"Summing it up she said that the ECB needs to do more than the market is pricing. It doesn’t get any clearer and money markets have ratcheted up their hike discount accordingly, with the terminal rate shifting up 27bps to 3.1%," ING strategists said in a note.

Data showing an easing in German producer prices in November for the second month in a row added to signs that high inflation could be waning in Europe's largest economy as the cost of natural gas and electricity is dropping.

But this offered little relief to the bond market, which was still reeling from the fallout from the BOJ.

Italian yields rose, with the 10-year up 9.5 bps at 4.47%, while the two-year rose 5 bps to 3.17%. Spanish 10-year yields rose 11 bps to 3.40%, while Greek 10-year bonds last yielded 4.44%, up 12 bps.

Reporting by Amanda Cooper; Editing by Emelia Sithole-Matarise and Alexander Smith

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