Bunds fall but summit uncertainty underpins markets

LONDON: German government bonds slipped on Wednesday with higher risk assets such as stocks performing after more solid US earnings and on signs of progress on a US deficit-reduction deal.

But caution ahead of a summit of euro zone leaders on Thursday underpinned the Bund market, where benchmark 10-year yields are at eight-month lows well below 3 percent.

With fallout from the region's debt crisis spreading to Italy and Spain, German Chancellor Angela Merkel has doused expectations that any comprehensive solution to Greece's debt crisis would emerge from the summit.

"Stocks keep reacting to decent earnings but the risk is for massive disappointment tomorrow," a trader said.

"Merkel is only being realistic as there's unlikely to be a pan-European solution announced. Hopes there would be stopped the rot yesterday but the market is trading very simplistically at times."

Spanish and Italian 10-year yields were around 10 basis points lower at 6.03 percent and 5.66 percent respectively.

"Even in the case of Greece, we doubt a complete, detailed, watertight package will be there tomorrow," Commerzbank rate strategist David Schnautz said.

"We may be a step closer but doubt that the market will be very pleased with such an outcome...the latest setback for Bunds and tighter spreads already has a lot baked into the cake in terms of what could be in the offing and disappointment potential could have the upper hand."

Cyprus central bank governor Athanasios Orphanides meanwhile warned that the country may need to ask for financial support unless drastic action is taken to deal with the impact of an explosion that severely damaged a major power station last week.

September Bund futures were 30 ticks lower at 128.75. Two-year German yields were 3 basis points higher at 1.280 percent, with 10-year yields up a similar amount at 2.715 percent.

Germany will sell 2 billion euros of 30-year bonds, with the auction seen meeting decent demand after a 10-year sale last week drew less in bids than the amount on offer.

"As Germany will sell a rather small amount of 30-year Bunds and this will be the only 30-year auction this quarter, the auction should be more easily digested," UniCredit MIB strategist Chiara Cremonesi said.

The last sale of 30-year paper in April met strong demand as yields neared 4 percent but the recent flight-to-quality bid has left long-dated yields around 60 basis points lower.

But some analysts warned other recent 30-year auctions had not gone as well. A sale in January, for example, when yields were at similar levels, also saw bids of less than the amount on offer.

The market will scrutinise more closely a sale of 10- and 15-year Spanish bonds on Thursday after 10-year yields soared above 6 percent on contagion from the euro zone debt crisis.

"If we get some more relief into the sale and a strong auction, we may avoid the 6 percent handle for the 10-year but that is not yet a given," said Commerzbank's Schnautz.

If yields did top 6 percent "it will highlight again what kind of territory Spain is now in."

Portugal will auction up to 1 billion euros of 3- and 6-month t-bills on Wednesday.

European shares opened higher, tracking overnight gains in Asia on signs of progress towards an 11th-hour deal to avert a US debt default and forecast-beating results from Apple.

Copyright Reuters, 2011