LONDON: German government bonds fell and peripheral paper rallied on Wednesday on growing optimism Greece will avoid a disorderly debt default in the short term, with the better market sentiment weighing on a five-year German debt sale.
Greece's parliament holds a crucial vote -- expected between 1100 and 1400 GMT -- on whether to submit the country to unpopular austerity measures demanded for the release of crucial funding to avoid a debt default.
Peripheral bond yields fell ahead of the vote, with 10-year spreads over German Bunds up to almost 40 basis points tighter in the case of Portugal and two-year Greek bond yields down over a percentage point to edge below 28 percent.
"A relief rally will be short-lived but relief there will be," said Nick Stamenkovic, rate strategist at RIA Capital Markets.
"For a significant improvement on the periphery we need to see Greece implementing these measures and history shows their ability to reduce the deficit is poor and there's growing resistance to further austerity measures."
With markets looking for the vote to pass, a surprise rejection of the measures would see an unwinding of the recent rally in risk assets and a sharp fall in bond yields potentially to the recent lows below 2.85 percent for 10-year Bunds, analysts said.
September Bund futures were 51 ticks lower at 126.05, 1.5 points below Monday's highs.
UBS technical analyst Richard Adcock said a break below Tuesday's 126.16 low would be a fresh bearish trigger, which could open the way to 125.70 and the June 14 low at 125.32.
Ten-year yields were up 4 basis points at 2.972 percent.
"Assuming the vote gets passed, it's quite toppy here at the moment, a lot of froth," said ING rate strategist Padhraic Garvey.
"We can very easily give up 10, 20 or even 30 basis points given where it currently is."
But any downside is expected to be capped for the time being, with the vote on austerity measures seen only as a first step.
If Greece approves the legislation, euro zone finance ministers meeting in Brussels on Sunday are likely to agree to release the next aid tranche, with the IMF following on July 5.
Attention will then switch to a second longer-term rescue package for Greece with banks and insurers considering a French plan under which private bondholders would reinvest part of the proceeds of maturing Greek debt in new 30-year bonds.
"There is a rather ominous track record of peripheral relief rallies being followed by further bouts of turmoil and of interested parties effectively using the better tone to stake out their next key point of contention," Nomura strategists said.
"This is an especially moot point ahead of the Eurogroup meetings."
Two-year bond yields were 5 bps higher at 1.525 percent, underperforming after European Central Bank President Jean-Claude Trichet signalled the debt crisis had not derailed plans for a July interest rate rise. The 2/10-year yield curve has flattened around 5 basis points this week.
POOR DEMAND AT GERMAN AUCTION
The selloff in core debt weighed heavily on a German five-year bond sale, where the amount of bids did not cover the 6 billion euros of paper on offer. And the bid/cover ratio, taking into account the amount retained by the Bundesbank was just 1.1, compared with an average at five-year German auctions this year of 1.76, according to Reuters data.
"Of course this was difficult paper to sell in a bearish session, but this auction is worse than expected, as was last night's five-year US Treasury auction," said Credit Agricole rate strategist Peter Chatwell.
"With a longer-term view, weak core five-year auctions are a good indication that the rally in core paper has run its course."
Five-year German paper was close to its most expensive levels versus two- and 10-year paper this year after the maturity outperformed in recent weeks as markets pared back ECB rate hike expectations as the Greek debt crisis intensified.
The 2/5/10-year barbell -- based on swap rates -- which falls when the five-year sector of the curve outperforms, was near its lowest levels since November going into the auction at around -1 bps, according to Reuters data and was last at 2 bps.
The sale was weak despite the bond being the cheapest to deliver into the futures contract and with almost 40 billion euros of German coupon and redemption payments due on Monday.
Yields on 10-year US notes surged 10 basis points on Tuesday after the Treasury's $35 billion five-year notes auction drew the weakest demand in a year.
Copyright Reuters, 2011
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