LONDON: Italian short-term government bonds rose on Tuesday as investors' choices for euro zone debt offering meaningful returns become fewer, but underlying worries about the bloc's debt crisis were likely to cap further gains.
The European Central Bank's cut in interest rates to record lows earlier this month and investors' preference for safe haven assets have pushed German and Dutch two-year yields into negative territory in recent days, while French, Austrian and Belgian yields traded just above the zero mark.
Investors are expected to pay a premium to Germany to look after their money for the first time ever at Wednesday's two-year debt auction.
Some market players unsatisfied with the yields available in top-rated countries snapped up the relatively riskier Italian paper on Tuesday, but traders warned volumes were low and dominated by domestic banks, a sign that the rally may not last.
Comments by Italian Prime Minister Mario Monti voicing "grave concerns" that autonomous region Sicily may default, reminded investors of the debt problems Rome was facing.
Two-year Italian yields were 14 basis points lower on the day at 3.91 percent, outperforming equivalent euro zone paper. They have fallen as low as 3.80 percent -- their lowest since the ECB meeting on July 5 -- but bounced back up after Monti's comments.
"There have been some (flows) into the short-end, people are looking for a little bit of yield there," one trader said. "But look at what is going on with Sicily!"
German debt also rebounded after Monti's comments, with Bund futures last trading flat on the day at 145.04, having dipped as low as 144.62 earlier in the session
Bund futures traded in a relatively narrow 144.50-145.30 range this week, with markets looking for clues from Federal Reserve Chairman Ben Bernanke about what could be the odds for further monetary policy easing in the United States.
In his testimony before the US Congress, Bernanke only reiterated the Fed's pledge to act if needed. His comments sent stocks lower and gave a boost to the dollar but did not move European debt markets.
"Some people in other markets may have been positioned for him saying something about QE3 (a third round of quantitative easing) and they took off those bets really quickly, but in Bunds there were very little flows today," a second trader said.
Safe-haven flows have already pushed German Bunds to elevated levels and a break below last week's highs around 144.30 may be needed for volumes to pick up.
Reuters data showed just over 500,000 lots had exchanged hands in the Bund futures market by 1530 GMT, less than half the volumes recorded a month ago.
SPAIN STILL UNDERPERFORMING
In contrast to fellow struggler Italy, Spain did not see much cash flowing into its short-dated debt. Two-year Spanish bonds yielded 4.81 percent, some 17 bps more from the previous day.
Any lasting respite was seen as unlikely and international investors were steering clear of the paper on fears the country will ultimately need a full sovereign bailout.
Although the country's borrowing costs dipped from a month ago at a 3.5 billion euro bill sale, they remained high by historic standards.
The auction was the first since Spain announced more austerity plans last week and was an early test of sentiment before a 3 billion euro bond sale on Thursday at which bonds with maturities of up to seven years will be on offer.
"The backdrop for short-term paper in general ... has clearly improved, and this includes bills but also short-term bonds," said Commerzbank strategist Rainer Guntermann.
"It would be too early to conclude that this is a positive for the bond auction ... the environment remains fairly fragile and vulnerable to general swings in risk-on/risk-off mode.
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