LONDON: Italian and Spanish bond yields fell for the ninth session on Wednesday ahead of the European Central Bank's offer of three-year cash which is set to ease bank funding concerns and give support to bonds from troubled euro zone economies in the near-term.
In extremely thin trading conditions, safe-haven German government bonds fell with markets optimistic the three-year funds would be reinvested in higher-yielding debt issued by the states at the sharp end of the euro bloc's crisis.
"We need to see something quite significant in terms of outcome in order to underpin an upside surprise, perhaps 350 billion euros, whereas 250 billion could potentially be seen as a disappointment given how much buoyant demand is already priced in," said Rabobank rate strategist Richard McGuire.
Banks cut their take-up of one week cash on Tuesday and took 142 billion euros in a one-day bridging operation, suggesting they were freeing up collateral and that there will be strong demand for the longer-term cash.
A Reuters poll showed euro-zone banks were expected to snap up 310 billion euros although forecasts ranged widely with some analysts seeing as much as 550 billion euros. A large portion of this is likely to be funding rolled from shorter-dated operations.
"The market's whipped itself into a bit of a frenzy and there's optimism for a large take-up, although that's somewhat in the price now," said a trader.
"Once this is done that's going to be pretty much it for the year," he added.
March Bund futures were 15 ticks lower at 137.34, having this week failed to break above last Friday's high at 138.86.
UBS technical analyst Richard Adcock said a further sell-off was possible in coming days to the support at 136.72, the 38 percent retracement of the rally seen in November and December, although this was expected to hold.
Trading volumes have collapsed below 300,000 lots a day for Bund futures this week, less than half volumes seen in recent months.
Ten-year German yields were 2.5 basis points higher at 1.976 percent.
Equivalent Italian bond yields were 7.5 bps lower at 6.56 percent, with Spanish yields 4 bps lower at 5.09 percent.
"Market reaction (to the ECB tender) is likely to be more significant for a downside surprise," said Rabobank's McGuire, adding that much of the recent rally in Spanish bonds could be reversed quite quickly.
For now however, although spreads over Bunds are wider, in outright terms, 10-year Spanish yields are lower than they were at the beginning of the year despite the market volatility since then. Total returns on Spanish government bonds this year are currently 6.4 percent, according to Evolution Securities, quoting iBoxx data, compared with 9.3 percent on Germany Bunds.
"A bold ECB allotment could...provide additional relief for peripheral markets and in turn weigh on Bunds, even though the air on the downside may get thinner with 10-year yields having corrected higher close to 2 percent," Commerzbank strategists said in a note.
But other analysts say the market may be getting overly optimistic that the cash will be used for the so-called carry trade - where investors borrow cheap funds to invest in higher yielding assets - as banks face a funding crunch next year.
According to the European Banking Association banks face a 700 billion euro wall of funding redemptions, most in the first half.
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