Bunds jump after Fed pledge to keep rates low

LONDON: German government bonds rose on Wednesday, pulled higher by sharp gains in US Treasuries after the Federal Reserve pledged to keep interest rates near zero for at least two more years.

Ten-year Treasury yields dropped below those of German Bunds for the first time since mid-June and yields on shorter-dated US debt plunged, with two-, three- and five-year notes all setting new lows.

Analysts speculated that the central bank would ultimately need to implement new stimulus measures.

"There's a fear that the outlook is very bad if they're committing until 2013," a trader said.

US T-notes yielded 6 basis points less than Bunds, having yielded 2 bps more than the German benchmarks at Tuesday's settlement, and whether the outperformance continues is likely to depend on developments in the euro zone debt crisis.

"If it gets worse people are going to buy Bunds but then you see people beginning to distinguish between the core countries and it depends on what the ultimate solution is and who is going to foot the bill," said Lyn Graham-Taylor, rate strategist at Rabobank.

Reflecting that, the cost of insuring against a French and German default has been rising, with five-year German credit default swaps up about 30 bps this month and French equivalents up 40 bps, according to date from Markit.

September Bund futures were 50 ticks higher at 132.91, having hit one-year highs of 133.96 in after-hours trading on Tuesday, before retreating as equity markets clawed back some of the ground lost this week.

Ten-year German yields were 4 basis points lower at 2.322 percent with two-year yields down 4.7 basis points at 0.729 percent.

Money market rates have priced out any expectations of an ECB interest rate hike and have even begun to price in a cut, but Rabobank's Graham-Taylor said heavy safe-haven flows were also a big part of the fall in two-year yields.

The ECB has raised rates twice this year, most recently by 25 basis points to 1.5 percent in July.

"Rate expectations have come out of the equation to a degree, but so much of that pricing is a credit judgement and people buying Bunds because they're more likely to pay back than anyone else."

Euro zone peripheral debt yields were modestly lower with the European Central Bank continuing to buy Italian and Spanish bonds and traders reporting there had also been a small amount of "real money" buying too.

Although doing little to tackle the underlying problems of high deficits and sluggish growth, the buying has seen yields on 10-year bonds issued by the two countries fall almost 100 basis points to near 5 percent, containing the euro zone debt crisis for the time being.

But policymakers have yet to implement plans for a second rescue package for Greece and an enlargement of the euro zone's rescue fund, the European Financial Stability Facility (EFSF).

Highlighting political divisions, a poll showed a majority in German Chancellor Angela Merkel's conservative party are opposed to recent efforts to stem the debt crisis.

"The background mood music coming from the politicians isn't great, people still feel the EFSF needs to be upsized" said a second trader. "And the ECB probably don't want to push spreads too tight until they see austerity being implemented."

ITALY AUCTION

Italy calmed some nerves, selling 6.5 billion euros of one-year bills at lower yields.

"It's probably not a really big hurdle for Italy but it has passed it and passed it very well," said WestLB rate strategist John Davies.

ING rate strategist Alessandro Giansanti said the ECB would probably have to buy around 35 billion euros of Italian bonds just to support bond auctions to the end of the year.

That figure represents the amount that foreign buyers would normally purchase out of the roughly 70 billion euros Italy has yet to raise, he said, although if the ECB wanted also to keep yield spreads down it would have to buy nearer 50 billion euros.

The big test for Italy will come with longer-maturity BTP auctions at the end of August.

Copyright Reuters, 2011