German bonds steady as disinflation keeps pressure on ECB

LONDON: German bond yields edged lower on Thursday as euro zone inflation fell to its lowest in nearly five years, maintaining pressure on the European Central Bank to keep monetary policy loose.

The moves were contained by some expectations that a rebounding U.S. economy could encourage the Federal Reserve to raise interest rates, a move that would likely impact benchmark government bonds across the globe.

Releases of U.S. jobless claims and Chicago PMI later on Thursday will be watched, but the main event for the market is Friday's nonfarm payrolls, which economists predict will drop to 233,000 from 288,000 last month.

A recovery in the labour market is seen as key to persuading the Fed to raise rates.

"The ECB is far away from tightening policy, but in the U.S. this prospect is much closer," said Piet Lammens, a strategist at KBC.

Having given up some 6 basis points late Wednesday after the U.S. economy recorded a surge in output for the second quarter, German 10-year yields steadied on Thursday, inching 1 basis point lower to 1.15 percent

While the euro zone is vulnerable to a U.S. rate hike, many strategists think the European Central Bank's ultra-loose monetary policy should help cushion the blow.

"There is some degree of correlation but on a longer-term horizon, rates will have to decouple. If euro zone growth remains soft, the ECB has to be in play, and if anything in more of an easing mode," said Marco Brancolini, a rates strategist at RBS.

Brancolini said conditions for a material sell-off in German bonds were not there and 10-year yields should trade in a range of 1 to 1.25 percent. KBC's Lammens said an upwards resistance level of 1.40 percent should hold throughout August, while record low yields of 1.11 percent set earlier this week would be hard to break.

With the euro zone suffering from disinflation, as data showed on Thursday, ECB efforts to protect the bloc's vulnerable recovery cannot let up.

Preliminary data showed year-on-year consumer inflation dropped to 0.4 percent in July, from 0.5 percent in June and below economists' predictions.

The ECB cut all its interest rates in June and promised up to 1 trillion euros in cheap long-term loans to banks from September. It has also kept the door open to a programme of large-scale asset purchases, known as quantitative easing.

GREECE, PORTUGAL STRUGGLE

Greek bonds were the worst performers on Thursday, with yields rising sharply after data showed retail sales fell 3.8 percent on the year in May.

Ten-year Greek yields GR10YT=TWEB were up 14 basis points at 6.07 percent. Traders said the moves were exacerbated by thin volumes.

Portuguese equivalents also struggled, rising 3 bps to 2.63 percent, after the country's largest listed bank posted losses of 3.6 billion euros late Wednesday and warned of possible illegal activity.

Banco Espirito Santo has vowed to raise new cash to bolster finances and to investigate the losses. The Bank of Portugal said it would prefer if capital were raised from private sources, but that the country does have funds for a public bailout if one is needed. All other euro zone bond yields were a touch lower.