Euro zone yields drop as inflation lag keeps hawks at bay

LONDON: Euro zone government bond yields dropped across the board on Tuesday after Spanish inflation undershot expectations and a European Central Bank policymaker flagged low underlying inflation as a reason to remain patient on policy tightening.

Governing Council member Erkki Liikanen said underlying euro zone inflation may remain lower than expected even if growth is robust, so the ECB needs to remain patient in removing stimulus.

Initial estimates, meanwhile, showed that Spanish consumer prices rose by just 1.3 percent in March, below the expected 1.5 percent.

The ECB's target is for inflation of just below 2 percent.

"The market was priced for higher Spanish inflation - this number feeds into the narrative that spot inflation is still very weak," Mizuho strategist Antoine Bouvet said.

"Today's news is confirmation of the theme we have talked about that tightening policy is constrained by the euro rally."

The single currency has risen over seven percent against the dollar since the start of November.

Euro zone government bond yields, which had edged higher in early trade, dropped across the board as the morning session wore on.

The yield on Germany's 10-year government bond, the benchmark for the bloc, dropped to its lowest level in two months at 0.512 percent.

Southern European government bond yields, seen as key beneficiaries of loose monetary policy, dropped 2-3 bps.

5-STAR HIT

Earlier on Tuesday, the gap between Italian and Spanish 10-year borrowing costs reached its widest level in just over seven months in a market weighed down by Italian politics and the prospect of international trade protectionism.

The closely watched spread between the two peripheral countries' debt -- included in some market measures of political risk -- moved to 67 basis points, its widest level since August 23, according to Thomson Reuters data.

Though the move proved short-lived, the milestone indicates that the market is jittery, analysts said.

"We have a lot of hopes that US and China will find a solution on the trade issue, but it is still like a sword of Damocles hanging over the market," said DZ Bank analyst Sebastian Fellechner.

"Also, the risk of a coalition between the far-right and the far-left parties in Italy has gone higher."

He was referring to comments by the head of Italy's far-right League who said on Monday he was ready to talk to the anti-establishment 5-Star Movement about forming a government.