LONDON: German government bonds stabilised on Friday after the previous day's sharp rise in yields on the prospect of tighter monetary policy, but were hobbled by optimism that US jobs data will beat forecasts.
Bond yields pushed sharply higher and the curve flattened after the European Central Bank stunned markets by indicating it could raise interest rates as soon as next month.
"The market did what it should have yesterday but there wasn't much client flow so we may see that coming in today and the curve flattening didn't feel like it went far enough," a trader said.
Traders said there was however an unwillingness to put on new longer-term positions ahead of the US payrolls report which can cause sharp short-term market moves.
March Bond futures were 5 ticks lower at 122.82.
A stronger-than expected payrolls number could see futures test last month's 122.29 low, the 50 percent retracement of the the 2008-2010 rally, a second trader said, potentially opening the way to the 62 percent retracement around 119.30.
Two-year bond yields were down a basis point at 1.764 percent, their highest levels since January 2009, with 10-year yields also down 1 bps at 3.314 percent.
Analysts are expecting a first rate rise in April given ECB President Trichet's language on Thursday and markets are pricing a further two hikes by year-end.
"There are a lot of speculative longs in commodity markets, and if we see those come off we may see Bonds come back and some of those rate hike expectations unwound," said a second trader.
Morgan Stanley strategists note that two-year yields tend to trade at about 80 bps over the ECB's refinancing rate -- currently 1 percent -- during rate hike cycles and therefore see two-year yields heading above 2 percent.
The 2/10 year yield curve was at 155 bps, its flattest since late 2010. When the ECB last started a rate hiking cycle at the end of 2005, the 2/10 yield curve was at about 60 bps, flattening to near zero through 2007, according to Reuters data.
ING rate strategist Alessandro Giansanti noted the risk premium at the long-end of the curve related to increased government bond issuance prevented the bullish curve flattening, which is normally seen at the end of an easing cycle. But he sees room for around 60 bps of further flattening from current levels.
PORTUGUESE 2-YEAR YIELDS UP
Peripheral spreads widened modestly although analysts said higher rates would be a negative for the struggling economies.
"It could be that the market believes when push comes to shove, the policymakers will come up with the goods or there is an unwillingness to short the market given the ongoing possibilities of European Central Bank (bond buying)," said Richard McGuire, rate strategist at Rabobank.
European Union leaders from centre-right political parties meet in Helsinki and will discuss the euro zone debt crisis, trying to forge a common position before two critical summits later this month.
"The problem is that you have a two-speed Europe and a rate hike is going to hurt the periphery so it puts pressure on the EU leaders to come up with something," the first trader said.
The US February employment report is released at 1330 GMT and a Reuters survey forecasts 185,000 jobs were created although better-than-expected private sector jobs data earlier this week has heightened expectations of a stronger number.
"The surprise potential in today's release is tilted to the upside with chances in favour of bearish steepening ... on the US curve," Commerzbank strategists said in a note.
They added any potential bull-flattening in case of a downside surprise could be used to add to 2-10 Treasury curve steepeners versus Bond curve flatteners.
Two-year Portuguese bond yields rose to their highest since May after Lisbon said it would sell up to 1 billion euros of two-year bonds next week. Analysts said the small size and short maturity should help the sale.
The county's last sale, a syndicated 5-year deal, has traded underwater since its launch. The bond was quoted at 97.38, according to Reuters data, compared with an issue price of 99.76.
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