Euro zone inflation gauge, bond yields diverge after central bank moves

* Euro zone market inflation gauge and bond yields diverge

* Two often move in same direction

* Fed policy helps keep bond yields down

* BOJ lifts measure of inflation expectations

* Graphic: http://tmsnrt.rs/2doQlis

By Dhara Ranasinghe

LONDON, Sept 29 (Reuters) - Financial markets appear to see a rebound in inflation on the horizon even as bond yields fall, leaving investors asking whether this shows years of easy money are finally working or is just a pricing anomaly linked to the latest central bank policy twist.

The trigger for this rare break in what has been a lockstep link between nominal bond yields and gauges of inflation expectations was last week's Bank of Japan meeting, which unveiled an abrupt policy shift toward targeting long-term interest rates rather than just money printing.

That decision seemed to resonate quickly worldwide by lifting inflation expectations gauges in the United States and Europe as well as in Japan.

Analysts say that while the jury is still out on the BOJ's steps, and it is early days to judge whether a shift in sentiment is taking place, it does appear that market inflation indicators are responding to the BOJ.

Commerzbank (Xetra: CBK100 - news) rates strategist David Schnautz said a commitment by a central bank to "fix" nominal bond yields is inflationary because it encourages borrowers to take advantage of low rates.

"The BOJ is viewed as being at the frontier of non-conventional monetary policy," he said. "Maybe they are not going in the best direction for the liking of many people but they are trying something new."

Ten-year Japanese government bond breakeven rates have risen as much as 6 basis points since last week's BOJ meeting.

The U.S. bond market's gauge of investors' 10-year inflation expectations last week hit its highest levels since June on a pickup in oil prices and a perception of ongoing policy support from major central banks.

In Europe, the 5-year, 5-year breakeven forward, the European Central Bank's favoured barometer of market inflation expectations, has risen as much as 10 basis points in the past three weeks to around 1.35 percent.

As this graphic shows, http://tmsnrt.rs/2doQlis, that has put the gauge, which shows where markets see 2026 inflation forecasts in 2021, on a divergent path to the government bond yields they often track.

Benchmark German 10-year Bund yields are down roughly 15 bps since mid-September to minus 0.12 percent.

This is unusual because inflation or expectations of future inflation erode the value of the fixed income payouts on bonds. In theory, this should push yields higher.

TRACTION IN EUROPE?

In Europe, the spillover from BOJ policy on market inflation gauges could be greater than in the United States because what Japan's central bank does could become a model for the ECB.

Like the BOJ, the ECB is in the midst of quantitative easing to boost inflation and growth. While inflation breakevens are above record lows hit in July around 1.25 percent, they remain far below the ECB's inflation target of close to 2 percent.

"Put simply, the BOJ weighed on nominal yields but pushed inflation expectations higher," said Frederik Ducrozet, senior economist Europe at Pictet Wealth Management.

"I would expect the ECB in particular to gradually move towards some form of inflation overshoot commitment as well."

Many analysts expect inflation to pick up towards year-end -- partly reflecting higher oil prices -- which should boost market measures of euro zone inflation.

German annual inflation accelerated in September, hitting its highest level in 16 months, preliminary data showed on Thursday, in an encouraging sign for the ECB that its ultra-loose monetary policy is working.

Spain's harmonised index of consumer prices (HICP) this month exceeded the 0 percent threshold for the first time since June 2014. Between July and September, the inflation rate increased by 0.7 percentage points.

The ECB forecasts 2016 inflation at 0.2 percent and 1.2 percent next year.

"I'll be looking at inflation-linked markets when inflation goes up because if you don't have at least some traction on breakevens, that would be a huge concern for the ECB," said Pictet's Ducrozet. (Reporting by Dhara Ranasinghe; Graphic by Nigel Stephenson; Editing by Alison Williams)