LONDON: German Bund yields hit a record low after Ukraine accused Russia of moving troops across the countries' border, while lower-rated euro zone bond yields rose after above-forecast inflation readings tempered expectations of imminent ECB easing.
Ukrainian President Petro Poroshenko said on Thursday Russian troops had entered Ukraine, and said his security and defence council would meet to decide how to respond.
Bunds, which perform well in times of heightened uncertainty because they are seen as ultra-safe assets, saw their 10-year yields hit a new low of 0.89 percent.
Peripheral euro zone bond yields suffered after inflation data from Spain and some of the German regions pointed to a higher-than-expected number for the whole euro zone.
Inflation across the currency union was previously expected to fall to 0.3 percent in August from 0.4 percent in July. It is now expected to be at least stable, though still far below the European Central Bank's target of just below 2 percent.
The data is due on Friday.
"Slightly better than expected inflation data could probably delay expectations of QE and this is why the periphery is underperforming, while the latest headlines in Ukraine triggered a rally in core markets," said Patrick Jacq, a rate strategist at BNP Paribas in Paris.
Speculation that the ECB was getting close to announcing a large-scale asset purchase programme, known as quantitative easing (QE), grew after President Mario Draghi highlighted in a speech on Friday a "significant" fall in inflation expectations.
ECB sources said the central bank was unlikely to take new policy action next week unless August inflation figures showed the euro zone sinking significantly towards deflation. http://link.reuters.com/fug72w
Spanish and Italian 10-year yields rose 8 basis points to 2.22 percent and 2.45 percent, respectively.
INFLATION EXPECTATIONS
The five-year, five-year forward breakeven rate - the ECB's preferred measure of what the market thinks the inflation outlook is - has picked up since Draghi's speech on Friday in Jackson Hole, Wyoming.
The rate, which now shows roughly where investors expect forecasts of inflation for 2024 to be in 2019, had fallen by roughly 20 bps in less than a month before those remarks and was approaching its 2010 record lows of around 1.90 percent. It has since picked up to a shade above 2 percent.
Other measures still show very low long-term inflation expectations. Ten-year inflation swaps stand at 1.5 percent, while five-year swaps trade at 1 percent.
Two-year German breakeven rates, derived from the yield gap between conventional and inflation-linked bonds, are negative. Ten-year breakeven rates at 1.26 percent are not far from Japan's 1.18 percent. Japan has battled low growth and deflation for most of the past 20 years.
Spanish inflation, although higher than expected, fell in August to minus 0.5 percent.
"There are two scenarios. We're either indeed going towards a climate like that of Japan ... or we are in a massive bond bubble which at some point of course it will burst," said KBC strategist Piet Lammens.
Low inflation or deflation may create problems for the euro zone's lowest-rated economies' efforts to cut their debts. However, prospects of QE make those bonds attractive at this stage as the market sees the ECB as a likely heavy buyer at any price.
This ensured Italy was able to sell 8 billion euros of five- and 10-year bonds at record low yields.
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