ECB's cautious optimism on vaccine supports euro debt markets

By Dhara Ranasinghe

LONDON (Reuters) - German bond yields continued to hold below this week's two-month highs on Friday, with sentiment in euro zone debt markets supported by a perception that upbeat news on a COVID-19 vaccine will not stop central banks from delivering more stimulus to prop up growth.

News of a vaccine against the novel coronavirus is positive but it will take some time before this has a positive impact on economic activity, European Central Bank policymaker Pablo Hernandez de Cos said on Friday.

That echoed comments from the heads of the Federal Reserve and the ECB on Thursday that stressed the economic outlook remains uncertain.

"They all shared similar concerns that a potential Covid-19 vaccine would not end the economic challenges of the pandemic," said Deutsche Bank strategist Jim Reid.

Monday's upbeat news from Pfizer about a COVID-19 vaccine sparked a heavy selloff in U.S. and European bond markets as investors jumped to price in a brighter outlook.

That euphoria has faded as the week progressed, with latest coronavirus headlines again highlighting the toll the pandemic continues to take.

France said late on Thursday that there would be no easing for at least two weeks of the country's second lockdown, with the number of people hospitalised with the virus now higher than at the peak of the first wave.

Most 10-year bond yields across the euro area were lower in late Friday trade, with Germany's benchmark 10-year Bund yield down 1 basis point at -0.54%, 9 basis points below two-month highs hit earlier this week.

Still, the sharp selloff in bonds at the start of the week left Bund yields almost 8 bps higher on the week and set for their biggest weekly jump since August.

With the euro zone likely heading back into recession this quarter, the ECB has already said it would provide more stimulus in December.

This week's ECB comments and concern about the impact from the second wave of the coronavirus have reinforced that expectation.

A long-term indicator of the market's euro zone inflation expectations, the five-year, five-year forward, fell to 1.1555% having hit its highest levels since September earlier this week above 1.21%.

The ECB will discuss possible tweaks to its inflation target at a seminar next week, Finnish central bank governor Olli Rehn said on Friday.

Italy's 10-year bond yield was down 2 bps at 0.63%, keeping recent record lows of around 0.57% in sight and the gap over benchmark German Bund yields close to its tightest levels since early 2018.

In the bloc's money markets, ESTR, an overnight borrowing rate compiled by the ECB based on the previous day's activity, jumped to a four-month high of -0.548%.

(Reporting by Dhara Ranasinghe; additional reporting by Yoruk Bahceli, Editing by William Maclean, Kirsten Donovan)