LONDON: Euro zone bond yields fell back towards recent lows on Wednesday as investors worried about a no-deal Brexit and the state of US-China trade talks before an expected interest rate cut by the Federal Reserve.

The Fed is expected to cut rates by 25 bps later on Wednesday. With investors focused on central bank guidance for any further rate reductions, trading was predictably quiet.

Data published on Wednesday showed euro zone economic growth had halved in the April-June period and inflation slowed sharply in July, although bond markets already pumped up by a months-long rally were little moved.

Eurostat's preliminary flash estimate of gross domestic product growth in the euro zone showed the economy expanding 0.2% quarter-on-quarter, down from 0.4% in the previous three months, as expected by economists.

The headline inflation rate was the lowest in 17 months, heightening expectations for European Central Bank easing in September.

“The big picture is unchanged. The data pretty much supports the ECB signal that there is going to be easing in September," said Jan von Gerich, a fixed income strategist at Nordea.

He said the market would need to see disappointing purchasing managers' index survey data published later this week to push core euro zone bond yields deeper into negative territory.

Last week, the ECB set out plans for a package of stimulus measures but brought a halt to a bond rally by not cutting rates immediately.

Since then, risk aversion has drawn investors back to the safety of European government debt.

The benchmark 10-year German Bund yield rose 1 basis point to -0.409%, not far from the record low of -0.422%. French and Austrian bond yields rose as well.

Irish bond yields, which jumped on Tuesday on no-deal Brexit fears, fell as investors returned. The 10-year yielded 0.108% , more than 6 bps lower on the day and fully reversing Tuesday's rise.

The Ireland/Germany 10-year bond yield spread stood at 54.7 bps after widening to as much as nearly 60 bps on Tuesday, the widest in eight weeks.

“The fundamentals of Ireland are otherwise quite strong. But there's no denying that they will be one of the biggest losers of a no-deal Brexit," von Gerich said.

ITALIAN STAGNATION

Italian yields dropped marginally but were little changed after data showed the economy stagnated in the second quarter.

The 10-year Italian bond yield fell nearly 2 bps to 1.567% . Last week, at the time of the ECB meeting, the yield had dropped as low as 1.38%. Shorter-dated Italian bond yields also weakened on Wednesday .

Whether big investors come back to the Italian bond market over the next few weeks will be a good guide to how strongly investors believe the ECB will resume quantitative easing, since Italian bond markets should be one of the main beneficiaries, said Cyril Regnat, a fixed-income strategist at Natixis.

ING strategists said in a note there was a “poor risk-reward of chasing the rally in spread products, especially BTPs (Italian government bonds) given the headline risks relating to government tensions," they said.

Spanish 10-year yields dropped 2 bps to 0.329%, showing little reaction to a slowdown in the country's economic growth rate in the second quarter to a lower-than-expected 0.5%.

Despite slowing growth, Spain's economy appears unaffected by the absence of a new government three months after an election.

Copyright Reuters, 2019