LONDON: German bond yields rose to one-week highs on Tuesday after a drop in euro zone inflation triggered concerns about the extent and effectiveness of European Central Bank policy easing tipped for later this week.
Annual consumer prices in the 18-country currency bloc fell to the lowest since the debt crisis erupted, leading some investors to take profit on a recent rally, and raising pressure on the ECB to take radical action to protect the euro zone's fragile recovery.
"The price action today shows just how elevated ECB expectations had become given there is still potential for disappointment," said Michael Leister, a senior interest rate strategist at Commerzbank.
Economists surveyed by Reuters expected inflation to remain at April's level of 0.7 percent but a number of big banks had already slashed their forecasts to 0.5 percent - with a few predicting an even lower reading - after soft German inflation numbers on Monday.
When May's reading was confirmed at 0.5 percent, euro zone government bond yields, led by the German benchmark, rose as investors started to rethink their exposure.
German 10-year yields, the benchmark for euro zone borrowing, rose 6 basis points to 1.37 percent, pulling further away from a one-year low of 1.28 percent hit last week.
"While it puts further pressure on the ECB to do something more impressive, there is also a realization that valuations in the euro zone have become very rich given the underlying economic picture," said Anton Heese, co-head of European interest rates strategy at Morgan Stanley.
The surprisingly weak data also raised some doubts about the potency of immediate ECB easing plans, which are expected to include an unprecedented cut in the ECB's deposit rate into negative territory and measures aimed at boosting lending to small and mid-sized firms (SMEs).
"There's a reluctance to take aggressive positions before the meeting. It (the ECB) will need to exceed expectations to drive yields lower," said Jan von Gerich, chief fixed income analyst at Nordea.
Some, such as BNP Paribas strategist Patrick Jacq, say the ECB may even signal it will launch an asset purchase scheme, as other major central banks have done.
Others, though, believe there is still a decent chance the ECB may not take any action on Thursday despite strong forward guidance and the weakening inflation dynamic.
"Today's data does not unequivocally say there will be a rate cut, in my view," said Gianluca Ziglio, fixed income strategist at Sunrise Brokers, adding that he saw a 40 percent chance of no action at Thursday's meeting.
BAILOUT DELAYS
Borrowing costs in some of the bloc's most fragile countries also edged up from historic lows after the inflation data, although they still outperformed lower-yielding core bonds.
Italian and Spanish 10-year yields climbed 4 bps and 2 bps to 3.01 percent and 2.87 percent respectively, while Greek equivalents rose 11 bps to 6.37 percent.
Portuguese bonds also rose 1 bps to 3.69 percent , compounding recent losses after the country's prime minister said Portugal's international lenders cannot pay the last tranche of its bailout before a rejection by the supreme court of a series of austerity measures is resolved.
Strategists said Lisbon would find a way to plug the fiscal gap of about 700 million euros created by the ruling, helped by the cash buffers it has built up ahead of its bailout exit.
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