LONDON: Two-year German yields ground higher on Wednesday, tracking a recent rise in short-term lending rates as liquidity in money markets declined and investors absorbed supply.
Short-term money-market rates have been creeping higher as banks pay back long-term funding lent by the European Central bank at the height of the euro zone debt crisis.
"It's nothing to do with the credit risk of Germany," Alessandro Giansanti, senior rates strategy at ING.
"It's just expectations that liquidity will continue to disappear from the market, not only in the euro zone, but with possible tapering coming from the US"
Some in the market brought forward bets on when the Federal Reserve would begin to scale back its monetary stimulus after above-forecast US jobs data last week, although the consensus remains for a March move.
German 2-year yields rose 2.2 basis points to 0.22 percent, as the bond underperformed the rest of the curve.
Short-dated German bonds have come under pressure on signs of money-market tightening before year-end.
Euro-priced bank-to-bank lending rates hit fresh highs on Wednesday as expectations waned that the ECB would move soon reverse the drop in excess money-market liquidity.
A German sale of 4.38 billion euros of two-year bonds also kept the bonds on the back foot.
The auction drew bids for 1.7 times the amount on offer, compared with 2.2 times in November, even though yields were lower then. Bund futures rose 13 ticks to settle at 140.30.
Cash 10-year yields were 2 bps lower at 1.82 percent, retreating from a seven-week high of 1.89 percent hit last week. Yields have held in a 1.65-1.95 percent range since early October on subdued activity in the last weeks of 2013.
"Trading activity is now slowing significantly. It's a tight range and we expect a relatively constructive tone going into the end of the year," Patrick Jacq, Europe rate strategist at BNP Paribas said, adding he saw room for yields on German 5-10-year bonds to ease slightly.
FED WATCH
Other euro zone bonds were also range-bound with investors reluctant to place big bets before the Fed's Dec. 17-18 policy meeting.
A majority of economists in a Reuters poll published on Monday still expect the Fed to start trimming its bond buying in March, but the survey also showed some economists warming to the idea that it could come earlier.
A bipartisan budget deal announced in the US Congress on Tuesday would remove one obstacle to tapering.
"A change in the current (Fed) policy stance is a very close call," said Annalisa Piazza, market economist at Newedge Strategy.
"Given the recent developments for both the economy and the labour market, we cannot rule out a modest reduction in the size of the current asset purchases.
Otherwise, the Fed might announce some changes in the 'shape' of the current programme.
Belgian bonds outperformed other highly rated euro zone bonds after the country said on Tuesday it planned to issue less long-term debt in 2014 than it had in 2013.
"That has just triggered a bit of buying," one trader said. Ten-year Belgian yields fell 3 bps to 2.41 percent.
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