UPDATE 1-Euro zone bonds sell-off stops; inflation expectations at six-month highs

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds commentary and chart)

By Elizabeth Howcroft

LONDON, Aug 14 (Reuters) – Euro zone government bond yields fell on Friday, as a three-day sell-off showed signs of abating after the benchmark German 10-year Bund yield briefly hit a six-week high in early London trading, while inflation expectations rose.

Borrowing costs in Europe have tracked U.S. Treasuries this week, which have been driven to new highs by a deluge of debt issuance in the United States.

But the move started to ease on Friday and by 1027 the German 10-year Bund was down 1 basis point on the day at -0.425%, having earlier spiked to a six-week high of -0.392% .

Still, the benchmark yield was on track to end the week up 9 bps – its biggest weekly rise since the first week of June.

The sell-off of safe government debt was at odds with a broader risk-averse mood in global markets and was seen by analysts as a temporary correction resulting from uneven positioning.

Riskier Italian and Spanish yields were higher than their core counterparts, with the Italian 10-year yield slightly up on the day at 1.08% and Spain’s 10-year yield up 1 basis point at 0.38%, close to a 2-1/2-week high .

Spreads between core and riskier bonds grew – but remained narrower than in March, April and May. The European Central Bank’s asset purchases, as well as the European Union’s plan for a coronavirus recovery fund, have helped keep spreads narrow in recent months.

Investors’ expectations for inflation are rising – posing a risk to bondholders because the ECB’s asset purchasing programme targets inflation and if that target is met the central bank would have a reason to stop inflating bond prices.

A key gauge of long-term euro zone inflation expectations, the five-year, five-year breakeven forward, rose to a six-month high on Friday, having risen throughout August.

“One key feature of the markets in recent months has been that despite low and stable 10y nominal bond yields, a dramatically divergent move has occurred beneath the surface with real yields plunging to record lows and inflation expectations surging,” wrote Societe Generale strategist Albert Edwards.

Deutsche Bank’s global head of rates research, Francis Yared, said that for there to be a sustained rise in rates, there would need to be clear medical progress in curbing the COVID-19 pandemic, such as a vaccine, or a resolution in U.S. government negotiations on financial support to mitigate the impact of the coronavirus pandemic.

The U.S. government is still negotiating the terms of the next round of financial support to fight the pandemic.

The next flashpoint for global market sentiment is expected to be a virtual meeting between top U.S. and China officials on Saturday, at which they will discuss their Phase 1 trade deal.

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