LONDON: German Bund futures fell on Wednesday and Spanish and Italian debt prices rose as investors bet a second injection of three-year European Central Bank cash would further ease tension in the banking sector and boost the appeal of riskier assets.
The ECB is set to announce it will hand banks an expected half trillion euros, which could trigger a knee-jerk move higher in peripheral debt prices. But market participants said Italian and Spanish bond prices were already discounting the extra cash to some extent and were looking expensive.
Indeed, worries over the euro zone debt crisis have underpinned German bonds, with the Bund future rising as far as 140.20 on Tuesday - almost touching the record high of 140.23.
But ahead of the liquidity boost, the contract fell and German yields were higher across the curve.
This could make for a more unfavorable backdrop to a sale of 10-year German paper - due just after the announcement of the cash injection.
"Above 500 (billion euros), risk markets will react positively and we will see a setback in Bunds, which makes the timing of the Bund auction rather unfortunate," Marc Ostwald, strategist at Monument Securities, said.
"I expect the bid-to-cover ratio) to be a little bit soft. Simply because people don't know what reaction is going to be (to the ECB announcement), so why would people want to go in gung-ho?"
"Above 500 (billion euros), risk markets will react positively and we will see a setback in Bunds, which makes the timing of the Bund auction rather unfortunate."
The Bund future fell 26 ticks to 139.80 before the auction and 10-year German bond yields rose 2 basis points to 1.82 percent.
One trader said the fact that the Bund did not close above 140 on Tuesday was "a reasonably bearish signal" and that there could be a reversal closer to 139.
Two-year Italian yields fell 19 basis points to 2.30 percent and the Spanish equivalent shed 11 bps to 2.45 percent. Ten-year Italian and Spanish yields were also lower at 5.30 percent and 5.00 percent respectively.
"There is a lot of talk about money going into the short end of Italy and Spain (from the LTRO) and I think a lot of people have set up for that as well," the trader added.
FLUSH WITH CASH
The ECB liquidity should continue to ease Spain and Italy's access to market funding but the reaction would be more muted given how far peripheral yields had fallen since the first cash injection, market participants said.
"It's a law of diminishing returns," said Gary Jenkins, director of Swordfish Research, adding it was possible Italian yields could trade below 5 percent in two to three months.
"I think what's important is that the trend continues that Italy can tap the market for funds when necessary."
Analysts said the bid for German bonds was based on the view that the ECB cash buys the region time to gets its fiscal house in order but does not solve the underlying debt problems.
Adding to the uncertainty over efforts to overcome the euro zone's debt crisis, Ireland is to hold a referendum on the European Union's fiscal treaty, although a "no" vote would risk compromising its own lifeline. Ireland is one of three countries to have received a bailout due to the crisis.
The Irish/German 10-year government bond yield spread was a shade higher on the day at 512 basis points.
A decision by Germany's top court overruling government efforts to push decisions on disbursing euro zone bailout funds through a special fast-track parliamentary panel meeting in secret was also generally supportive of Bunds.
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