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Euro zone bonds reverse as inflation rises, takes heat off ECB

The new headquarters of the European Central Bank (ECB) is seen during a guided media tour in Frankfurt, April 29, 2014. REUTERS/Ralph Orlow
The new headquarters of the European Central Bank (ECB) is seen during a guided media tour in Frankfurt, April 29, 2014. REUTERS/Ralph Orlow

By John Geddie

LONDON (Reuters) - Euro zone bond yields reversed earlier gains on Wednesday after euro zone inflation cooled expectations that the European Central Bank would need to immediately loosen monetary policy to support the bloc's fledgling growth.

Consumer prices nudged above 2009 lows in April, although at 0.7 percent, inflation fell short of forecasts of 0.8 percent and remain well below the ECB's target of just under 2 percent.

Markets had earlier been positioning for inflation to fall even further below forecast, after flash estimates for Germany - the bloc's largest economy - released on Tuesday were 0.2 percent below economists' predictions.

"Market expectations changed after the German reading. So today's reading was actually at the higher end of what was expected," said Luca Jellinek, European head of fixed income at Credit Agricole.

German Bund futures dipped to a day's low of 144 after the data, down some 25bp on the day and erasing early gains. German bond yields rose 2 basis points to 1.52 percent, having hit 1.49 percent earlier, while Spanish and Italian equivalents rose 1 bps above day's lows of 3.06 percent and 3.11 percent respectively.

While the threat of deflation keeps alive the chances of a more accommodative stance from the ECB, strategists say more evidence is needed to spur action.

"One set of data is not enough," said Eric Oynoyan, Europe rates strategist at BNP Paribas. "If inflation falls back again, that will up the pressure."

The ECB next meets on Thursday May 8, although few in the market predict any surprise policy action then.

However, ECB policymaker Christian Noyer added further fuel to the speculation by saying he was personally in favor of one or two further measures, for example injecting more liquidity.

Strategists say such measures are likely to include a further cut in official rates or an end to a process whereby the ECB drains euros from the banking system equal to its own holdings of government bonds bought at the height of the crisis, or sterilization of its Securities Markets Programme.

A programme of asset purchases, or quantitative easing, which the ECB has referenced as a possible tool, is also on the cards. Italian Economy Minister Pier Carlo Padoan reiterated on Tuesday, however, that the implementation of such a programme would prove difficult.

Immediate pressure on the ECB from money markets is expected to ease, with the euro zone overnight bank-to-bank lending rate tipped to fall from multi-year highs as 100 billion euros that was injected into the euro zone banking system on Tuesday filters through.

TIMING CRUCIAL

European market participants will now turn their attention to events in the US, seeking clues for when the world's largest economy will raise rates, a move that is likely to be felt across continents.

Later on Wednesday, US Federal Reserve officials are not expected to deviate from continued tapering of its massive bond-buying stimulus at the end of its two-day meeting. Neither is it likely to provide any more guidance on rates rises, predict strategists, leaving ADP employment data as the key indicator.

"The Fed is on autopilot regarding tapering, thus the labor market data will be key regarding the market's take on the timing of the first interest rate move," said Commerzbank analyst Alexander Aldinger said.

(Editing by Larry kIng)

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