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ECB action may end bond yield fall

Monday, May 19 12:49:39

Any European Central Bank move to print money could raise investors' expectations for euro zone inflation and growth, pushing German Bund yields higher and potentially halting a two-year-old rally in peripheral debt.

Euro zone bonds have gained in recent weeks on growing expectations the ECB will eventually start buying government debt with new money to help bring inflation back to its target of just under 2 percent from 0.7 percent in April.

The central bank would have to pay a high price for those bonds and investors are buying them now with a view to selling them to the ECB for a profit later.

But if the ECB embarked on a programme of quantitative easing, or QE, investors would then have to consider that it was intended to boost longer-term inflation and growth and yields on benchmark 10-year bonds would have to adjust higher.

"If you start credible QE the market has to price a non-zero probability it would work, and that means Bund yields would rise," said Laurence Mutkin, global head of G10 rates strategy at BNP Paribas.

He said any QE would also raise the floor for yields on debt issued by fragile euro zone economies. While the gap between Bund yields and peripheral yields could narrow, outright peripheral yields "had less scope to fall".

Marco Brancolini, rates analyst at RBS, said bond yields also rise when central banks launch bond-buying programmes because investors tend to see it as the final act in a monetary policy easing cycle.

"Once the easing cycle bottoms down, the market has no more easing information to price in and starts looking forward to the hiking cycle," he said.

ECB policymakers have said QE is a possibility but that any programme remains far off and could be tricky to design given the peculiarities of the currency union.

Reuters reported last week that the ECB is preparing a package of policy options for its June 5 meeting, including cuts in all its interest rates and targeted measures aimed at boosting lending to small- and mid-sized firms.

In the United States, the Federal Reserve has launched three QE programmes in the past six years. Each time U.S. 10-year T-note yields rose by roughly 1 percentage point from the moment QE was announced before pausing.

Analysts say a rise of 1 percentage point in Bund yields from the current 1.30 percent is unlikely, given that growth prospects in the euro zone are weaker than in the United States.

Gerard Moerman, head of rates and money markets at Aegon Asset Management, said he would probably be a seller of Bunds if the ECB launched QE, but he would be a "happy" buyer once yields hit 2 percent.

Brancolini at RBS said Bund yields could fall towards 1.10-1.15 percent in anticipation of QE, then bounce.

"We see fair value nearer 1.50 percent. In the event that QE is actually undertaken, we would tell investors to sell after the announcement," he added.

Mutkin at BNP Paribas looks at the difference between the yield on a conventional bond and that on a similarly-dated inflation-linked bond - the so-called breakeven rate, which is a measure of the market's inflation expectations. (Reuters)