Bunds hold steady as focus shifts to Fed

LONDON: Bunds held steady on Tuesday, with the impact of an Italian ratings cut fading and investors reluctant to add significantly to their German debt holdings before the Federal Reserve decides how far it is willing to loosen monetary policy.

The Fed, beginning a two-day meeting later on Tuesday, is poised to increase downward pressure on longer-term interest rates by extending the maturity of its Treasury assets. Any bolder move may take fixed income markets by surprise and hit Bunds.

Fears about Greece's ability to secure its next international aid tranche remained, however, and funding strains in euro interbank markets intensified, keeping a bias in the market for further near-term gains for Bunds.

German 10-year yields were last 0.4 basis points lower at 1.801 percent, having earlier fallen as low as 1.734 percent, just above record lows at 1.681 percent.

"Ahead of the Fed you probably don't want to run these large positions testing all-time lows for Bunds ... there may always be a surprise," said WestLB rate strategist Michael Leister.

Italy's 10-year bond yield spread over Bunds briefly reached 397 bps in the session, before falling back to 389 bps, up about 10 bps on day.

One trader said the spread narrowing from session wides was caused by a few small bids for Italian paper in thin trade. Other traders cited talk of European Central Bank buying Italian and Spanish debt, although they had not seen the flows.

Standard & Poor's cut Italy to A from A+, preceding any move by Moody's, which was expected to be the first major credit ratings agency to downgrade the country. S&P now rates the country three notches lower than Moody's and two notches lower than Fitch.

"It is ... a reminder that there will be pressure on the ratings of some other countries," said Rainer Guntermann, strategist at Commerzbank.

Italian 5-year credit default swaps rose 27 bps to 515 bps, according to monitor Markit. The cost to insure the country's debt against default has risen rapidly in recent weeks, while cash bond yields have been kept relatively contained by ECB purchases.

"(The CDS level) shows that the market is increasing pressure on the ECB," said WestLB's Leister. "There are always break-ups between market segments but at the end of the day things converge simply because of economic reasons."

"You would expect that pressure on Italian bonds should also increase markedly. The ECB will probably have busier weeks ahead in terms of buying Italian and Spanish bonds."

Bund futures last traded four ticks lower on the day at 137.39, having risen as high as 138.14. Reports that Bank of China had stopped foreign exchange forwards and swaps trading with three top French banks supported Bunds in early trade.

DOUBTS OVER GREECE

Greece, in a telephone call with senior officials of the European Union and the International Monetary Fund on Monday, promised as many austerity moves as necessary to secure its next aid tranche but the lenders warned implementation was key.

Talks with the lenders resume later on Tuesday. Traders said they were still wary on Greece, which has a poor reform record and is off track with its fiscal targets.

"Talks seem to be going well in Greece, but I'm not convinced," a third trader said.

Greek five-year credit default swaps were quoted 60.5 points up front, up 3.5 points on the day.

Greece sold 1.63 billion euros of three-month treasury bills at a yield of 4.56 percent.

Copyright Reuters, 2011