LONDON: German government bond yields edged higher on Wednesday before a smaller-than-usual auction of five-year debt, which could signal how high investors think the chances are that the European Central Bank will cut interest rates.
Most analysts polled by Reuters say the ECB will hold fire at its meeting on Thursday, but euro zone inflation came in at 0.5 percent in March, below forecasts.
That has kept alive speculation that policy will loosen.
Germany plans to issue up to 3 billion euros of five-year debt later in the day.
A recovering economy, a balanced budget and low interest costs allow Berlin to hold smaller auctions, since it plans to issue only 205 billion euros of debt this year, compared with 247 billion euros in 2013.
The small offering means that the auction is likely to be overbid and it will have little impact on the secondary market, analysts said.
But the level of overbidding could signal what investors expect from the ECB meeting. Five-year debt is usually more sensitive to central bank policy expectations than two- or 10-year issues.
Five-year bonds outperform their peers when expectations of looser monetary policy grow, as investors search for higher yields in longer-dated maturities and expect the tightening cycle to start later. Conversely, when investors are think rates will not loosen soon, five-year bonds underperform.
"Today's auction might be supported by demand coming from those investors who are willing to open long positions ahead of the ECB policy decision on Thursday," said Annalisa Piazza, market economist at Newedge.
The previous five-year auction a month ago saw investors bidding 4.586 billion euros, 1.4 times the amount sold at an average yield of 0.64 percent.
Five-year German yields hit a two-week low of 0.565 percent on Friday after low inflation figures from Spain and Germany.
They have since retreated to trade 1 basis point higher on the day at 0.66 percent on Wednesday, indicating bets of further ECB easing have already been pared.
Ten-year yields rose 1.5 bps to 1.596 percent, also bouncing off last Friday's two-week lows of 1.513 percent.
Upbeat US economic data this week, including manufacturing surveys, contributed to the rise in yields.
"ECB easing expectations have been pared and the gradual improvement in US data supports higher yields as well.
There's more room for core yields to go higher," said Jan von Gerich, chief fixed income strategist at Nordea.
Most other euro zone bond yields were 1-2 bps higher.
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