LONDON: German government bonds fell on Tuesday after the region's growth and inflation expectations were revised upwards and as investors positioned for a heavy schedule of core euro zone debt issuance this week.
Euro zone inflation climbed as expected in February to its highest level since October 2008 -- well above the European Central Bank's target -- fuelling speculation the ECB will have to act at some point to contain price pressures.
Meanwhile, the European Commission said the European economy is likely to grow faster than expected this year but inflation could rise as well.
With prices now being driven from the front-end of the yield curve, Thursday's ECB meeting will be key.
"History shows us the market tends to increase their (rate) forecasts further once the tightening cycle starts," said Nomura rate strategist Sean Maloney.
"Much of what's expected to happen in the near-term is already priced in but that makes it more of a two-way risk, rather than just fading the weakness at the short-end because there could be more to come."
Attention will be sharply focused on the bank's latest assessment of the threat of higher inflation and markets are also waiting to see whether the ECB will resume withdrawing its emergency liquidity support.
March Bund futures were 17 ticks lower at 123.95, with 10-year yields up 2 basis points at 3.191 percent. Two-year bond yields were at 1.544 percent.
Oil prices rose again as unrest in the Middle East and North Africa threatened to further reduce crude supplies. But equities rose and traders said Bonds were unlikely to benefit much more from safe-haven buying.
"It feels like we've seen the support we're going to see. It's in the price now," said one trader.
"The market is trading as though Libya will be over quite quickly but the worry is if there is a lot of contagion to other countries."
CORE SUPPLY WEIGHS, PERIPHERY OUTPERFORMS
With the March bond futures contracts expiring next week, Nomura notes the short-positioning bias across all maturities. With most of these positions expected to be rolled into the June contracts -- by buying March and selling June contracts -- the spread between the March and June prices are expected to widen in coming days, Maloney said.
Austria sold 1.2 billion euros of 2015 and 2022 paper on Tuesday and the Netherlands is in the market with 5 billion euros of new 10-year bonds.
Up to 27.5 billion euros worth of bond sales are expected by Friday with Germany and France also issuing paper this week, adding to pressure on core debt prices as dealers and investors make room for the new bonds.
Euro zone government bonds saw a slightly negative return of 0.02 percent in February in local currency terms, fairly in line with US bonds which lost 0.07 percent, but underperforming Gilts, which gained 0.76 percent, data from Citigroup World Government Bond Index showed.
Spanish debt saw the biggest return among euro zone bonds last month with a 0.37 percent gain, while whose who invested in Portugal posted the biggest losses at 1.52 percent, Citi said.
With only around 4 billion euros of issuance from Spain on Thursday, peripheral supply pressure has eased this week and the euro zone's higher-yielding issuers outperformed German debt.
But the periphery is struggling to make real headway ahead of a European Union meeting later this month where leaders are expected to agree to raise the size and scope of the euro zone bailout fund as Germany is under domestic political pressure to resist such moves.
"It is in the progressive fading of investors' goodwill toward EU leaders that we see reasons for further upward pressure in peripheral spreads over the next few weeks, especially in light of German Chancellor Merkel's domestic electoral problems," Lloyds Bank strategists said in a note.
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