LONDON: Bund futures held close to record highs on Wednesday ahead of a German auction and Spanish benchmark yields flirted with 6 percent, with spreading doubts about the euro zone's ability to contain its debt crisis dominating market sentiment.
Investors took a breather in their flight to safe havens as Germany prepared to launch a new 10-year bond, with a sharp rally on Tuesday exaggerated by thin liquidity prompting Bund futures to fall 34 ticks to 139.98 - still within sight of the all-time high of 140.52.
But with the market appearing to be losing confidence that Madrid can exercise the fiscal discipline needed to control public finances amid a faltering global growth outlook, analysts said another selloff of peripheral debt looked on the cards.
"With the (German) supply coming in, I guess this has induced players to book some profit for the time being," said Michael Leister, strategist at DZ Bank in Frankfurt.
"But, overall in our view the momentum remains intact and we will approach these record highs in the Bund future sooner rather than later."
Spanish 10-year yields tested 6 percent on Tuesday but backed away from that level to fall 5 bps on Wednesday to reach 5.93 percent as some of the speculative accounts looked to take profits on short positions.
"At 6 percent or 5.75 percent the yield signals that the market isn't really confident - this is rather a pause than a turnaround," Leister said.
Spanish industrial output data showing a larger-than-expected drop underscored the dilemma facing the government as it tries to generate economic growth while still implementing deficit-cutting austerity plans.
"This time it is not so much that investors hadn't priced in the debt problems as much as it is the sluggish response of the euro zone economy to the structural reforms being implemented," analysts at interdealer broker Tradition said in a note.
SUPPLY DYNAMICS
German 10-year yields rose 4 basis point to 1.68 percent, backing away from the record low of 1.637 percent that was matched in the previous session.
With yields remaining at rock-bottom levels, the launch of a new 10-year Bund later in the session will be closely watched for any sign that a low return on investment is deterring buyers.
But Societe Generale analysts expected the auction to fare better than the launch of the previous Bund in November last year which drew extremely weak demand at a time when yields were also near record lows.
"In contrast to today, that poor auction came on the heels of several weak auctions, with little cover. Similar weakness should not be seen this time round, with the market now familiar with sub-2 percent Bund yields," the bank said in a note.
Supply also comes from Italy in the shape of a an 11 billion euro sale of six- and 12-month bills, which were expected to be easily absorbed, aided by the recent rise in yields.
"Yields rose pretty sharply yesterday so there's already one hell of a concession built in there," a trader said.
Italian debt has suffered alongside Spanish paper in recent sessions on fears that serious funding problems for Spain would spill over into the euro zone's other highly-indebted economies.
The 10-year Italian yield was down 9 basis points on the day at 5.60 percent, but with few long-term accounts looking to take long positions, traders said the scope for a major rally in the bonds was limited.
Italy's auction of up to 5 billion euros of BTP bonds on Thursday could be the catalyst for a fresh rise in yields as dealers sell existing debt to make room for the new issue, market participants said.
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