Bund yields set for biggest annual fall in two decades

LONDON: German government bonds held steady on Friday, the last trading day of 2011, but benchmark 10-year yields were set for their biggest annual fall since at least 1990, with investors seeking a safe haven in the euro zone crisis.

Ten-year yields have fallen almost 40 percent in 2011, according to Reuters data, eclipsing the fall seen in 2008 at the height of the financial crisis.

Safe-haven paper is likely to outperform further early next year with concerns over Italy's cost of funding adding to pressure on the periphery. Italy faces around 100 billion euros of bond redemptions and coupon payments by the end of April.

"At least in the first quarter we can see Bunds clearly outperform their euro zone peers," said Commerzbank strategist David Schnautz.

"While that might not be visible in outright yields as there is perhaps not so much downside from these levels, the renewed supply avalanche and fallout on the ratings front will put firm upward pressure on spreads."

Standard & Poor's is expected to decide in January whether to downgrade the 15 euro zone countries, including Germany and France, it has on credit watch negative.

Italian bonds were steady early on Friday after the European Central Bank stepped into the secondary market on Thursday to stabilise yields in the wake of a disappointing bond auction.

After the sale Italian Prime Minister Mario Monti sought reinforcement for the euro zone's bailout fund and pledged new efforts to boost the economy.

Longer-dated Italian paper has been among the worst performers this year according to the Markit iBoxx index posting total returns of minus 11 percent.

Despite the ECB's bond buying programme and Italy agreeing a 33 billion euro package of cuts and tax hikes, 10-year yields remain above 7 percent, a level seen as unsustainable.

Shorter-dated paper has performed better however, rallying since the ECB said in early December that it would provide banks with unlimited three-year funding. Banks helped themselves to nearly half a trillion euros of the cash last week, with the opportunity to take more in February.

Although there is scant evidence banks will use the cash to buy higher-yielding assets, the rally in shorter-dated Italian and Spanish paper has seen yield curves steepen sharply, by around 140 basis points in the case of Italy.

March Bund futures were 7 ticks lower at 138.85 after testing Thursday's 138.96 high, a level that must be cleared if futures are to retest their euro-era highs.

Two-year bond yields were half a basis point higher at 0.17 percent after touching euro-era lows of just 0.14 percent earlier this week with banks preferring to invest some of the ECB's three-year money in the highly liquid paper.

Most, however, was making its way straight back to the ECB's deposit facility with 445 billion euros left there overnight.

Reflecting banks' unwillingness to lend to each other, at the same time overnight borrowing jumped to 17.3 billion euros as banks stocked up on funds to cover the year-end period .

Ten-year yields were steady at 1.84 percent in thin holiday trading volumes which are exaggerating price moves.

Copyright Reuters, 2011