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 LONDON: Bund futures fell on Wednesday after reports of a deal to increase the firepower of euro zone rescue fund eased safe-haven demand, despite subsequent denials, though trading was set to remain volatile until an EU summit this weekend.

Two senior euro zone sources dismissed a report in Britain's Guardian newspaper that France and Germany had agreed a deal to boost the euro zone bailout fund to 2 trillion euros.

Nevertheless, a rally in riskier assets hit appetite for low-risk German debt and outweighed the effect of another Spanish credit rating downgrade, this time by Moody's.

December futures fell more than a point on the day to a session low of 134.32, extending early falls after an auction of German debt drew weak demand against the backdrop of improved risk appetite.

"It's a nervous and headline-driven market today and probably for this week," said Commerzbank strategist Rainer Guntermann.

Trading was expected to remain volatile and driven by swings in sentiment over whether policymakers will reach a deal to draw a line under the euro zone crisis at an EU summit this weekend, analysts said.

Ten-year German yields were likely to end up near current levels around the 2 percent mark heading into the summit, Guntermann said, with officials appearing keen to temper any rapid build-up in expectations.

"The politicians certainly want to give the impression ... that they are ready to provide something bold, but at the same time they don't want expectations to get too much ahead of themselves," he said.

The yield on 10-year German debt was last at 2.11 percent, up 9 basis points on the day, with two-year yields at 0.636 percent, up 5.7 bps.

Traders said that despite the recent selloff many longer-term investors still held positions reflecting the view that the crisis response would fall short and drive cash yields lower in the medium term.

THIRD CUT IS THE DEEPEST

Moody's downgrade of Spain's credit rating by two notches to A1 -- the third, and deepest, downgrade to the country's rating by a major rating agency in recent weeks -- drew limited reaction from markets.

The 10-year Spanish yield was 1.5 bps higher at 5.381 percent, near its highest since the European Central Bank began buying Spanish and Italian debt in a bid to cap rising borrowing costs.

However with Bund yields rising sharply, the 10-year Spanish/German yield spread was actually narrower on the day at 327 bps.

The downgrade followed similar moves by Fitch and Standard and Poor's and, although anticipated, was likely to hurt demand for Spanish bonds before debt sales on Thursday which, along with French auctions, were seen as important gauges of market sentiment.

"Tomorrow's French and Spanish auctions are a big risk. Especially because if we get a leveraged EFSF then France's rating is definitely under review," said Vatsala Datta, strategist at Lloyds Bank in London.

Investor nerves over the security of France's triple-A rating put upward pressure on French yields after Moody's issued a warning shot on Tuesday in its annual report on France.

The 10-year yield spread over German Bunds briefly tested its widest levels since 1992, reached on Tuesday.

 

Copyright Reuters, 2011