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Euro zone bond yields may be in for New Year shock as ECB cuts buying

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12/14/2017 | 05:03pm CEST
The European Central Bank headquarters are pictured in Frankfurt

LONDON (Reuters) - Euro zone government bond yields are close to multi-month lows just as the European Central Bank is on the verge of cutting its bond-buying scheme by half, leaving some investors worried that a sharp correction may be due in 2018.

While bond markets are among the most liquid in the world, some participants believe the trillions pumped into them by central banks have distorted yields so much that they are not reflecting the impending reduction of financial stimulus.

"It's consensus to say that the sharp deceleration of central bank purchases is priced in ...(but) I think it's very difficult to price in that deceleration ahead of time when the weight of central bank money is so strong," said Jim Reid, head of global credit strategy at Deutsche Bank.

"When you've got that relentless buying from central banks it's difficult to see how fixed income markets can be a rational two-way market."

The ECB has already injected 2.55 trillion euros ($3 trillion) into markets by buying government and corporate bonds in an attempt to ward off deflation and revive a euro zone economy ravaged by debt crises between 2010 and 2012.

However, the euro zone is set for its best growth in a decade this year and the deflation risk has receded. So in January the ECB will cut asset purchases by half from to 30 billion euros a month until at least September 2018. Many expect the quantitative easing (QE) scheme to end next year.

This prospect ought to lower bond prices and consequently push up yields sharply. Yet the yield on Germany's 10-year government bond, the benchmark for the region, dropped as low as 0.29 percent this week. This compares with 0.48 percent in October. <DE10YT=TWEB>

Such relentless demand for high-grade government debt has baffled some people in the market. "It's a mystery," said a trader at one European bank, asking to remain unnamed.

SHARP CORRECTION

Many believe a sharp correction from January onwards is possible when the ECB purchases begin to fall. This could be amplified by copious supply that traditionally hits the market through a concentration of bond auctions at the start of every year.

"At the moment, the ECB is buying roughly 2.5 billion euros of government bonds every single day on average. Starting January this will go down to something like 1 billion euros a day," said Said Haidar, president and chief executive officer of Haidar Capital Management, a $365 million global macro hedge fund.

Haidar based his projection on analysis of ECB buying patterns in recent times and the suggestion that it will keep corporate bond purchases more or less steady, making most of the reductions in government bond purchases.

"Bond yields have fallen quite significantly recently because of the lack of supply and the ECB purchases. Well, both of those factors will reverse in January and we could see a repeat of last year, where Europe outperformed U.S. by 30 bps in at the end of the year and then underperformed 30 bps in January," he said.

Indeed, the gap between German and higher U.S. 10-year borrowing costs widened as much as 50 basis points in the last quarter of 2016, as U.S. Treasury yields rose sharply following the presidential election. This reversed in the first quarter of 2017, and the spread tightened as much as 40 basis points.

While the move has not been as dramatic this time, German debt has steadily outperformed its U.S. equivalent since September.

"It makes sense for (euro zone) yields to rise more, that's certainly our expectation for 2018 with the ECB likely to tighten policy and perhaps end QE altogether," said John Taylor, a fixed income portfolio manager at asset manager AllianceBernstein.

"I can see some volatility in euro govvies, but the serious rise in yields will likely happen as we approach September. One way or another, we expect yields to rise next year."

(Reporting by Abhinav Ramnarayan and Helen Reid, Graphic by Ritvik Carvalho; editing by David Stamp)

By Abhinav Ramnarayan and Helen Reid

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