Inflation drop pins peripheral bond yields at multi-year lows

Lower-rated euro zone bond yields held near multi-year lows on Monday, with a drop in euro zone inflation keeping speculation rife that the European Central Bank may loosen monetary policy further later this year.

Euro zone inflation slowed to 0.5 percent in March from 0.7 percent the previous month and compared with expectations of a 0.6 percent reading in a Reuters poll. Markets had already been positioned for a below-forecast figure after subdued inflation numbers from Spain and Germany on Friday.

The ECB is not expected to cut interest rates at its monthly meeting on Thursday, a Reuters poll showed.

Even if the ECB does not ease policy, it is likely to keep rates at record lows for a long time to bring inflation back towards its target of just below 2 percent.

That would keep yields on top-rated euro zone debt at ultra-low levels, pushing investors towards lower-rated bonds as they try to maximize returns.

Italian 10-year yields were flat on the day at 3.31 percent, having hit an 8-1/2 year low of 3.261 percent on Friday. Spanish yields fell 1 bps to 3.23 percent, just off an eight-year low of 3.20 percent.

Portuguese yields fell 2 bps to 4.03 percent, having dipped below 4 percent for the first time in four years on Friday. Irish yields were 4 bps off their record low of 2.974 percent.


"The numbers point to low (rates) for longer from the ECB, which is an environment in which the periphery should flourish because everybody is hunting for yield," said Marius Daheim, chief strategist at Bayerische Landesbank.

German Bund yields, the benchmark for euro zone borrowing costs, rose 3 bps to 1.58 percent, having fallen to two-week lows of 1.51 percent on Friday.

Traders attributed the move, which was counterintuitive given the low inflation, to investors booking profits on last week's rally as they cautiously positioned for the ECB meeting.

Some also pointed to comments on Saturday by ECB policymaker and Bundesbank chief Jens Weidmann that the euro zone was not in a deflationary cycle and that the ECB should not over-react to a slowdown in inflation which should prove temporary.

Market participants said that marked a change in tone from last week, when he said negative rates were an option to temper euro strength and that buying loans and other assets from banks to support the zone's economy was not out of the question.

Money markets, the best gauge of expectations of what the ECB is likely to do, pointed to little chance the ECB would ease monetary policy on Thursday. Forward overnight euro zone bank-to-bank Eonia rates dated for April were 0.175 percent, only 2 bps below the spot Eonia rates.

Eonia rates dated October through December were around 0.13-0.14 percent, indicating that the market sees an increasing chance of ECB easing towards the end of the year.

"There's definitely some expectation that they will do something further down the line," ICAP strategist Philip Tyson said. "That sort of (inflation) number does keep the pressure on the ECB to act."

(Editing by Gareth Jones)