LONDON: The German yield curve resumed its recent flattening trend on Wednesday as short-dated bond yields rose more than those at the longer end of the curve with economic fundamentals continuing to back rising interest rates.
The difference between two- and 10-year German yields narrowed by around 2 basis points to 157 bps after hawkish comments from European Central Bank policymakers and data showing both growth and inflation momentum remained positive in the euro zone's larger economies.
"Inflation continues to push higher and we saw German official forecasts for growth revised upwards -- it's consistent with a bear flattening move and expectations of more from the ECB," said Patrick Jacq, strategist at BNP Paribas in Paris.
Ten-year yields should hit 4 percent by the end of the year with the two-/10-year spread likely to flatten to 110-120 basis points, Jacq said.
The 10-year German bond yield was flat at 3.448 percent, while the two-year yield settled 1.6 bps higher at 1.88 percent.
ECB Governing Council member Mario Draghi said interest rates remain very accommodating even after last week's hike and the bank is looking at ways to withdraw from its "exceptionally expansionary" monetary stance.
Expectations that the ECB would continue to raise interest rates were also supported by above-forecast French inflation data and newspaper reports that Germany will raise its 2011 growth forecast to 2.6 percent.
Nevertheless, assuming no major shocks to risk appetite, traders expect Bund yields to consolidate around current levels for the next few days, taking a breather after a rise of about 40 bps over the past three weeks.
The 3.5 percent level in 10-year yields remained a key technical resistance level after yields have failed to sustain brief breakthroughs on a closing basis.
GERMAN AUCTIONS
Earlier, Germany sold 1.67 billion euros of 30-year bonds, drawing strong demand from institutional investors attracted by yields at almost 4 percent, their highest in more than a year. It also smoothly sold 2.76 billion euros worth of seven-year, inflation-linked bonds.
"A lot of institutionals, like pension funds and insurers, are looking for duration and obviously a yield pickup, and for quite some time they have been forced to move out further along the curve," said WestLB strategist Michael Leister.
"Four percent is the key level that, especially insurers, are looking at given they have to meet their return targets."
Elsewhere, Greece said it would present new fiscal and privatisation plans on Friday in an attempt to convince investors it can meet the terms of its EU/IMF bailout and avoid restructuring its debt.
Greek and other debt issued by the euro zone's lower-rated states were steady, though traders said the frequency of headlines about haircuts was increasing and could eventually renew pressure on peripheral bonds.
According to UniCredit strategist Elia Lattuga, the market is fully pricing in a roughly 30 percent haircut on the Greek 5/30 year curve and about 80-85 percent probability of a 50 percent haircut across those maturities.
The calculations use Greek/German yield spreads, are based on the assumption that German debt is risk free and take into account haircuts on the coupons as well. The figures are volatile, subject to fluctuations in the spreads.
Lattuga said his view was more cautious than the market's.
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