German bonds see-saw after tame TLTRO raises QE question

LONDON: German bonds see-sawed on Thursday as investors weighed up whether a tepid response to the ECB's new long-term loans would prompt the central bank to find new ways to revive the region's ailing economy.

Yields initially rose just after European markets opened, reacting to projections of steeper rate rises from the U.S. Federal Reserve. They fell after the ECB announced it would provide 82.6 billion euros of new long-term loans to banks, much less than the 133 billion euros predicted by money managers in a Reuters poll.

Strategists said the initial move showed investors were speculating that the bank would have to resort to a full-blown asset-purchase programme, or quantitative easing (QE). But by 1100 GMT yields were back where they were before the release of data on take-up for the bank's targeted long-term refinancing operation, or TLTRO.

The take-up was "a clear disappointment after (ECB President Mario) Draghi had said the ECB was aiming to expand its balance sheet considerably," said Nordea's chief strategist, Jan von Gerich. "Expectations of a larger QE programme are set to increase again, supporting bonds and keeping the euro under pressure."

Many banks, including Nordea, expect greater demand for the next round of TLTROs, in December, as banks become more confident after the results of stress tests due next month.

German 10-year yields were 2 basis points higher at 1.03 percent, having been as low as 0.997 percent.

Lower-rated euro zone bond yields extended gains after the ECB announcement. Italian, Spanish and Portuguese 10-year yields all fell to the day's lows.

Of those, Spanish 10-year bonds were the best performers. Their yields fell 5 bps to 2.25 percent as fears eased that a vote for Scottish independence in Thursday's referendum would encourage Spain's own Catalan separatists. The latest polls put Scotland's unionists a whisker in front.

That bodes well for Spain, which sold 3.5 billion euros of a new three-year bonds at record low yields on Thursday.

Commerzbank strategist Benjamin Schroeder said demand for the bonds was helped by expectations banks might re-invest the new four-year ECB loans in short-dated peripheral debt such as the Spanish debt. The ECB has said banks will have to hand back the loans after two years if they do not use the money to lend to the real economy.

For money markets, the focus will now turn to the latest repayments of three-year ECB loans, handed out at the height of the crisis in late 2011 and early 2012. Those payments are due on Friday.

As long as repayments remain below the new loan injections, excess liquidity should increase in the weeks ahead, pushing down euro overnight interbank rate fixings (EONIA).

Overnight EONIA has crept back into positive territory in recent days, even though the ECB cut its deposit rate to minus 20 basis points at its last meeting. This has been due to a decline in excess liquidity of nearly 100 billion euros.

Commerzbank said even a small injection of net liquidity could render levels of minus 8 bps realistic.

Elsewhere, French 10-year yields were 1 bp higher on the day at 1.42 percent after the country sold around eight billion euros of new bonds at auction as well as inflation-linked paper.

Markets appeared to shrug off a report in the French newspaper L'Opinion that Moody's ratings agency would downgrade France's sovereign debt rating on Friday by one notch, to Aa2 from Aa1.