Bunds rise but room for disappointment on ECB

LONDON: German government bonds rose on Thursday ahead of a news conference at which the European Central Bank is expected to indicate a halt to the interest-rate rise cycle to help boost the struggling economy.

The ECB left its main refinancing rate on hold at 1.5 percent after raising it twice in the last five months. But new inflation and growth forecasts from its economists are likely to be revised down, giving it cover for a change in policy direction.

The market may have limited room to move, however, if the ECB delivers as expected, with Eonia overnight forward rates already pricing in the chance of a rate cut later this year.

"People have priced quite a lot in and we're at fairly extreme levels but there's unlikely to be a change in the general trend for the moment, even if there's some disappointment today," a trader said.

RBC Capital Markets strategist Peter Schaffrik said that if Trichet indicated anything other than a relatively neutral stance, the biggest moves would probably be seen around the December Euribor contract.

"If he gives a hint of an actual rate cut, that would be significant, or if they indicate they're essentially ruling one out, that would be significantly more hawkish than the market is expecting," Schaffrik said.

"We're currently pricing in a 25 basis point cut by November and if there's a hint of a cut, the market will speculate on a decent chance of a 50 basis point cut."

That would also see implied rates fall across the Euribor strip, he added, as the market priced in lower rates for longer.

December Bund futures were 71 ticks higher at 136.86, having retreated from record highs set on Monday, with benchmark 10-year German yields down 5 basis points at 1.826 percent as a rally in equities lost steam.

Safe-haven Bunds are expected to remain well supported for now with no sign of a permanent solution to the euro zone debt crisis and uncertainty over the implementation of a second Greek aid package.

"Until we get back above 2.08 percent in 10-year Bund yields -- that's a crucial level -- there's room to go down to 1.70 percent," the trader said.

The 2.08 percent level acted as technical support in the second half of August.

Greek two-year yields were indicated as much as 150 basis points higher at more than 60 percent in early trade as German Finance Minister Wolfgang Schaeuble said Greece must fulfil the conditions needed to be a member of the euro zone and warned the country may not receive further aid unless it met fiscal requirements.

Ten-year Italian bond yields drifted higher to 5.25 percent after "aggressive" ECB buying on Wednesday pulled them down from around 5.6 percent after Rome overhauled an austerity plan.

Traders said the ECB was active again on Thursday.

The Italian Senate on Wednesday approved the government's widely criticised austerity programme which now passes to the Chamber of Deputies, where Prime Minister Berlusconi has a slimmer but still stable majority.

"We've seen the ECB will only support Italy if it delivers on what it promises on the fiscal front," said BNP Paribas rate strategist Matteo Regesta. "So any disappointment on that front will push yields higher."

Two-year bond yields were 1.6 basis points lower at 0.478 percent after moving off record lows on Tuesday.

"There is not much to suggest (the yield) will move much higher from here," said Credit Agricole rate strategist Orlando Green.

"The ECB's tone today should confirm that front-end yields should be anchored and that any curve shape moves will likely be determined by the longer parts of the curve. The likelihood in the near-term at least, is for the Euro market to bull-flatten."

Copyright Reuters, 2011