Long-dated euro zone bonds sell off as risk appetite bounces back

Longer-dated debt led a selloff in eurozone bonds on Thursday on signs of progress in resolving the U.S.-China trade war, and as investors seized on recent doubts about whether a European Central Bank stimulus package next week can match expectations.

After a strong price rally in August, eurozone bonds have stumbled in recent days. Reduced political risk, from the approval of a coalition government in Italy to the UK parliament's battle to avert a no-deal Brexit, have improved investors' mood, reducing demand for safe-haven government debt.

On Thursday, China's commerce ministry said Beijing and the United States agreed to hold high-level trade talks in early October in Washington, easing fears that the escalating trade war will trigger a global recession. Richard McGuire, head of rates strategy at Rabobank, said the easing of investor appetite for safe-haven assets is more likely to weigh on longer-dated bonds.

"The bid for safe havens had flattened curves and now this is being modestly retraced, although these are big moves on the day," he said. Thirty-year euro zone bond yields were 11-12 bps higher on the day, with Germany's 30-year yield set for its biggest jump since April 2017 -- up over 10 bps to -0.076%.

Comments by ECB policymakers this week also appeared to dampen expectations for aggressive stimulus at next Thursday's ECB meeting. "Investors are a little bit concerned that the ECB won't act as expansionary as expected," said Daniel Lenz, a rates strategist at DZ Bank.

Lenz said that the market would likely struggle for direction until the ECB meeting either disappointed investors or sparked another leg in the rally. He also noted that this week's ECB comments fit into a pattern of policymakers raising expectations, before dampening them in the weeks preceding a meeting to give themselves room not to disappoint on the day.

The 10-year German Bund yield rose over 6 basis points to -0.61%, its highest in almost two weeks and above Tuesday's record lows of -0.743%. Italian bond yields also rose after falling all week as investors welcomed the formation of a government that could prove to be more fiscally responsible than the last.

The 10-year Italian yield rose 8 bps to 0.90%, off Wednesday's record low of 0.803%. Italy's 50-year yield echoed other longer-dated bonds, up 16 bps at 2.27%. Analysts say that if after the recent plunge in yields, many international investors remain underweight Italian bonds and with the yields relatively attractive, more could pile back in.

DZ Bank targets the Italian/German 10-year bond yield spread at 120 bps -- 30 bps lower than current levels. However, the picture for Italian government bonds (BTPs) could quickly turn if the ECB's stimulus package underwhelms on Sept. 12, as Italy is expected to see the biggest impact from a large stimulus package.

"What makes BTPs vulnerable to me is that some ECB members are unwilling to re-open quantitative easing. As we broke below 150 bps [on the spread] yesterday, it makes sense to have some profit-taking," said Natixis fixed income strategist Cyril Regnat. Heavy bond supply also pushed yields up with Spain and France selling more than 14 billion euros of bonds.