Bunds rally on worries crisis will topple Italy, Spain

LONDON: German government bonds rallied to their highest in almost a year on Wednesday, supported by a dismal outlook for global growth which increased pressure on Spain and particularly Italy, as the euro zone debt crisis intensified.

Fears that Washington's efforts to cut spending will slow growth when global industrial activity is already sluggish saw equities slide and demand for safe-haven assets increase.

Worries about Italy's huge public debt has pushed yields to 14-year highs, bringing the euro zone's third-largest economy closer to full-scale financial crisis less than two weeks after policy makers agreed a deal aimed at ring-fencing contagion from Greece, Ireland and Portugal.

"For both Spain and Italy the 7 percent level in yields is the one everyone is focused on," said WestLB rate strategist Michael Leister.

"Although we're still quite a decent amount away from that, any break of the 6.50 percent level is going to be a catalyst to get to those higher rates."

Spanish and Italian 10-year yields were at 6.28 and 6.16 percent respectively in early trade, little changed on the day, with spreads over Bunds at 389 and 377 basis points.

The gap between higher-yielding 10-year Spanish bonds and equivalent maturity Italian paper narrowed to 16 basis points, down from around 40 basis points two weeks ago as Italian paper has underperformed.

"The slide in US growth expectations clearly comes with a very poor timing," said Commerzbank strategist Rainer Guntermann.

"The nervousness and spread volatility is unlikely to go away soon, especially as secondary market liquidity is fading, partly for seasonal reasons and partly because value at risk measures at some accounts suggests to stay sidelined or even point to the exit door."

September Bund futures were 30 ticks higher at 132.12, having earlier hit their most in almost a year at 132.63, with 10-year German yields down 3 basis points at 2.384 percent.

Two-year bond yields briefly dipped below 1.0 percent for the first time since January and were last at 1.04 percent.

"The markets benefiting from this are Bunds, Gilts and Sweden and Norway -- basically the fairly fiscally strong countries," a trader said.

Ten-year Belgian and French spreads over Bunds hit fresh euro era highs at 209 bps and 81 bps respectively, in a sign that Italy's underperformance has raised fears the euro zone crisis could hit core economies as well.

"Equities everywhere seem to be under a lot of pressure. (Belgium) is probably the next weaker nation after Italy. It is not surprising to me that they are struggling," a trader said.

Investors were bracing for US monthly ADP jobs data, a harbinger for non-farm payrolls data due on Friday.

"If you look at positioning in Treasuries it seems fairly neutral. People aren't particularly long, so they can certainly rally further if it's a weak print and take Bunds along too," a second trader said.

Ahead of that, data showed growth in the euro zone's dominant service sector eased to its weakest rate in nearly two years in July after the manufacturing series earlier this week showed the sector had all but stagnated.

Copyright Reuters, 2011