Euro zone bonds volatile as nerves remain over central bank action

(Updates prices for close)

By Abhinav Ramnarayan

LONDON, Oct (HKSE: 3366-OL.HK - news) 28 (Reuters) - Euro zone government bond yields seesawed on Friday as investors grappled with various economic data and what they may spell for inflation expectations and the future direction of central bank policy.

In early trades, euro zone government bonds looked set to sell off for a third straight day with yields hitting their highest level in months. But by the close of trading they were back where they started.

"Clearly it's not Bund tantrum 2.0," said ING rates strategist Martin Van Vliet, referring to a April-June of 2015 when the yield on Germany's 10-year government bond rose over 90 basis points over a seven-week period.

"I think a few people are realising the sell-off was a bit overdone, and so yields are falling now. Equally, though, if some inflation indicators next week come out higher than expected we could see selling pressures come back," he said.

Strong UK economic growth data on Thursday prompted a global bond sell-off as they reduced expectations for a rate cut when the Bank of England meets next week.

The world's largest economy, the United States, which many expect to raise interest rates for just the second time in a decade in December, also released some solid growth data on Friday.

A general sense that central banks worldwide are stepping back from the aggressive stimulus measures of recent years is seen as the catalyst for the sell-off in global bond markets which has pushed up yields in the U.S. and Europe to their highest levels since before Britain's Brexit vote in June.

Data also showed on Friday that Spain's economy expanded by 0.7 percent in the July to September period on a quarterly basis, in line with economists' forecasts.

Steadily improving growth and inflation prospects in the euro zone have added to market expectations that the European Central Bank will slow down the scale of its asset purchases.

"Speculation about tapering in Europe is increasing with inflation expectations improving, and the concern is that central banks will hit the brakes on stimulus - especially the ECB," said DZ Bank strategist Daniel Lenz.

Having hit a post-Brexit vote high on Thursday, the benchmark 10-year German Bund yield rose a further 5 basis points on Friday to 0.22 percent, its highest since early May. But by 1500GMT, it was back at 0.17 percent.

Most other euro zone bonds were also broadly flat on the day.

Some analysts said that a sense that the sell-off had overshot was partly vindicated by some dovish comments by top ECB officials.

Two policymakers said on Friday that the ECB will provide stimulus until a sustained inflation rebound, even as its unprecedented measures come with side effects and face constraints, just as the bank is contemplating more easing .

SUPPLY PRESSURES

Italy was the notable laggard in euro zone bond markets on Friday, with its 10-year government bond yields hitting their highest level since February as it sold 8.5 billion euros ($9.3 billion) of bonds in an auction.

Yields tend to rise around major bond sales as investors make room for the new supply, and Italy's auction comes on the back of a number of other euro zone auctions this week.

The yield on Italy's 10-year benchmark bond consequently rose to 1.60 percent ahead of the auction, and was around 1.59 percent at 1500 GMT, up 4 bps on the day.

Italy was also this week forced to defend its rule-breaking 2017 budget to the European Commission, saying that Europe's migrant crisis, post-earthquake reconstruction and lower-than-expected growth were to blame.

The spread between Italian and Spanish government bond yields is the widest it has been since December 2014, with concerns about a looming referendum on reform of the Italian Senate weighing on sentiment. (Reporting by Abhinav Ramnarayan; Additional reporting by John Geddie; Editing by Richard Balmforth, Larry King)