Spanish bond yields hit record lows as oil slump firms QE bets

LONDON: Spanish government bond yields fell to record lows on Monday as plunging oil prices bolstered expectations the ECB would soon do more to stimulate the region's economy, including purchasing sovereign bonds.

Oil's fall to 5-1/2-year lows has served to justify bets the ECB will take steps to fight off deflation, which swap rates signal could set in over the next year. Two-year inflation swaps are close to zero.

Investors snapped up Italian, Spanish and Portuguese bonds, which yield more than their German equivalents and are expected to outperform if the ECB introduces quantitative easing.

Even Greek yields fell, despite being shaken by political jitters in recent weeks.

"If the oil price shifts medium-term inflation expectations, it just increases the prospect of more ECB easing," said Anton Heese, co-head of European interest rate strategy at Morgan Stanley.

Economists polled by Reuters last week were near unanimous that the ECB would begin buying sovereign bonds within a few months.

Spanish 10-year bond yields fell almost 10 basis points to a record low of 1.785 percent. Portuguese and Italian yields were down 4-8 bps.

The German equivalents were up 1 bps at 0.63 percent. France's also rose slightly to 0.91 percent, after Fitch cut the country's credit rating to AA from AA+ on Friday.

The ECB's preferred measure of how the market reads the inflation outlook - the five-year, five-year breakeven forward - hit a record low of around 1.67 percent on Monday.

But governing council member Ewald Nowotny said that members are not already committed to sovereign bond buying and would have to take account of the overall economic situation.

The ECB is particularly interested in whether a fall in oil prices will prop up domestic spending in the euro zone, which some say could influence this month's preliminary factory and services output data due on Tuesday.

"We look for modest improvement in the composite reading on the back of a combination of lower oil prices and weaker exchange rate contributing to an improvement in confidence," RBC said in a note to clients.

With tepid demand for the ECB's bank loans last week, the running expectation is the central bank will need to expand this purchase scheme to boost its balance sheet by a planned one trillion euros.

The ECB bought 3.83 billion euros of covered bonds last week, taking the total to 24.756 billion euros. It has also bought 788 million euros of asset backed securities as of Dec. 12.