German bonds outperform US Treasuries as ECB policy easing eyed

LONDON: The two-year US Treasury note yield premium over German equivalents rose to a seven-year high on Thursday as German bonds outperformed on anticipation the ECB will ease policy later in the day.

Investors have been favouring euro zone bonds over US Treasuries in recent months as the European Central Bank primed markets for aggressive policy measures to support a frail recovery, while the US Federal Reserve has been trimming its monetary stimulus.

Some analysts see Thursday's ECB meeting paving the way for asset purchases, or quantitative easing (QE), similar to the Fed's bond-buying scheme that is now being wound back.

The two-year yield gap between the US and Germany - the euro zone benchmark issuer - hit just over 35 basis points, its widest since mid-2007, highlighting the policy divergence between the two.

"We think the widening in spreads will continue because the assumption is the Fed will start to raise official fund rates in the first quarter of next year while for the ECB this is still far away.

We might see the ECB start QE," said Alessandro Giansanti, a strategist at ING.

"The two-year spread can easily move up to 80 basis points and the 10-year to 150 basis points in coming months."

The 10-year T-note/Bund yield gap was at 118 bps and a rise to 150 bps would take it back to the widest in 15 years.

In one of the most anticipated meetings this year, the ECB is widely expected to cut interest rates by 10-15 basis points, slash the deposit rate into negative territory for the first time and inject liquidity into the banking system.

The consensus view that the ECB will act is so strong that some analysts see great scope for market disappointment if it fails to meet these expectations. "There's a lot priced into the market, maybe that's the risk.

(ECB President Mario) Draghi's language in terms of future action will be key.

The market is very long of periphery and the front end of core bonds. Any disappointment could see a violent reaction if they only deliver the basics," one trader said.

Italian 10-year yields were last 1 basis point down at 3.00 percent while equivalent Spanish yields were a touch lower at 2.88 percent, just above record lows hit last week.