LONDON: German government bonds fell on Tuesday, snapping a three-week rally after credit rating agency Moody's revised its outlook on the country to negative, but the sell-off was not expected to last with pressure on Spain and Italy rising.
Spanish bond yields rose further, albeit less than on Monday, with a successful sale of short-term debt offering little support as expectations grew Madrid will need a full bailout on top of an already approved rescue deal for its banks.
Italian yields followed suit, with shorter-dated yields rising more than longer-dated ones, sharply flattening the curve as investors saw greater credit risk.
The potential cost to the so-called core euro zone members of Spain and Italy requiring further support was one of the reasons cited by Moody's Investors Service for changing Germany's outlook, as well as those of the Netherlands and Luxembourg. It also cited the cost of containing fallout from a possible Greek euro exit.
But analysts said with a "sizeable" investor base obliged to invest in euro-denominated assets, the Bund sell-off was unlikely to last with the moves exacerbated before a German 30-year bond auction on Wednesday.
"There's still no better place to hide than Bunds...We don't see this bear flattening in Italy and Spain running out of steam yet. It's still very much safety first approach," Commerzbank rate strategist David Schnautz said.
Bund futures shed 52 ticks to settle at 145.03, off their earlier lows. Ten-year yields were up 6.5 basis points at 1.24 percent.
Traders reported selling of German paper by both long-term investors and "fast-money" accounts - such as hedge funds - as well as by dealers in early trading, but that had slowed down.
Bunds have underperformed both US Treasuries and UK gilts this week, something one trader called an "anti-euro bias" and some of last week's yield hunt which saw demand for French, Belgian and Austrian bonds has been unwound.
"The buyers of France and Belgium are still around but the flows have slowed to a trickle," a trader said. "They'll step back in if things get better but it's looking pretty grim for now."
DEBT SALES
The Netherlands, seen as relatively safe but with higher yields than Germany, found it tougher than usual to sell bonds after the Moody's action.
Germany will test demand for its ultra-low yielding paper at Wednesday's auction of 3 billion euro of 30-year Bunds. Some strategists said the relatively small size of the bonds on offer at the sale as well as its relative cheapness on the German curve after the Tuesday's rise in yields should help demand.
BNP Paribas strategist Eric Oynoyan recommended switching out of the 15-year Bund into the 30-year.
"Both the (French) OAT and Bund 15-year are trading to their richest levels of the past 18 months versus 10-year and 30-year maturities," he said
Spain paid its second highest yield to issue short-term debt since the introduction of the euro although analysts expressed cautious relief that the sale had gone smoothly.
"It is not going to reverse the generally weak trend that we have seen. The fears about the euro zone aren't going to go away...Bonos are a better reflection of investor demand," said Marc Ostwald, rate strategist at Monument Securities.
That demand has been minimal, sending Spanish bond yields to euro-era highs in illiquid conditions on concerns the government might lose access to debt markets and need a full bailout.
Ten-year Spanish yields were 10 bps higher at 7.60 percent but five-year yields rose above 10- and 30-year yields for the first time since at least June 2001.
Short yields have risen more than longer-dated ones, flattening the yield curve, a pattern seen before Greece, Ireland and Portugal were forced into asking for aid.
Two-year yields were up 16 bps at 6.77 percent after rising almost a percentage point on Monday after media reports on Sunday that up to half a dozen local authorities were ready to follow Valencia in asking for government aid.
Three EU officials told Reuters Greece is unlikely to be able to repay what it owes and will probably need further debt restructuring. The troika of international lenders returned to Athens on Tuesday to check Greece's progress in meeting the terms of its bailout.
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