LONDON: German government bond prices fell on Tuesday as lower-rated euro zone debt stabilised slightly, prompting investors to book profits in Bunds after their rally to near 8-month highs.
Some market participants were also pushing for cheaper Bund prices to make way for Wednesday's sale of 30-year German bonds.
Division among euro zone policymakers ahead of Thursday's summit, kept sentiment in peripheral debt markets fragile however, with few expecting a permanent solution to the debt crisis now threatening Italy and Spain.
"Today's moves are not a sign of a sustained trend it's just a bit of temporary respite after the sharp widening we saw in Italy and Spain yesterday," said Nick Stamenkovic, a strategist at RIA Capital Markets.
"Underlying sentiment remains pretty negative ... ahead of the key EU meeting on Thursday...If nothing substantive comes out of the meeting, Italy and Spain are going to be under further downward pressure and that will lead to renewed flight to quality into Bunds."
Italian BTP futures jumped 139 ticks to 100.38, recouping just a third of the falls seen over the past week, as Bund futures shed 53 ticks to 128.92.
Cash 10-year BTP yields were down 17 basis points on the day at 5.827 percent , narrowing the spread over benchmark Bunds to 313 bps. Spanish yields also fell but remained above 6 percent and within sight of their highest levels since the launch of the euro in 1999.
Traders said thin volumes as the northern summer break gets underway were also exaggerating market prices, with the volatility and uncertainty over the outcome of Thursday's meeting keeping fund managers away from peripheral bonds.
With just days to go before the summit, called to prevent the crisis from spreading through the region, European government officials and commercial bankers struggled to reconcile competing proposals for a second bailout for Greece.
European Central Bank President Jean-Claude Trichet also maintained his opposition to a solution that could lead to a debt default in Greece, in another sign that policymakers are still far from reaching a consensus before Thursday.
"You can argue that the summit isn't really focusing on the matter in hand to a degree. There's a risk we could get some disappointment in terms of help for Spain and Italy if the crisis gets worse on Thursday," a trader said.
"Spain especially is at very pronounced yield levels. Systemic risk is definitely the danger into the end of the week."
NETHERLANDS, AUSTRIA BENEFITS
Spanish 10-year yields have surged to euro lifetime peaks around 6.30 percent with a move above 7 percent considered unsustainable for the euro zone's fourth largest economy.
A Spanish bond sale on Thursday will be closely watched to see how much of a premium the country will be forced to pay to sell longer-dated paper.
The shakeout in peripherals is prompting improved flows into other triple-A rated countries with relatively sound economic fundamentals such as the Netherlands, Austria and Finland.
"Our analysis of last week's flow data supports the recommendation to buy quality," Citi strategists said in a note. "The largest buying last week was of the Netherlands, followed by Austria -- and the largest selling was of Spain."
Copyright Reuters, 2011