UPDATE 1-Euro zone bonds hit by BoJ auction, unfazed by weak inflation

Eurozone bond yields extended their move higher on Tuesday after a subdued auction of Japanese government bonds, while the market mostly ignored an expected weak reading of the region's inflation rate.

Government bond yields slumped to record lows in early September as fund managers, fearful of an economic downturn scrambled into government debt. But investors have since been cutting back on their bond holdings, believing European Central Bank monetary policy easing may have run its course for now. ECB President Mario Draghi's emphasis again on Monday on the need for fiscal policy to support the bloc's long-term growth prospects lifted yields at the start of the week.

On Tuesday, however, there was a more technical explanation for the higher yields. After the Bank of Japan this week cut purchases in long tenors, investor demand for a 10-year bond auction was weak and government bond prices slumped. That fed across to higher bond yields in major markets, with German, French and Spanish yields all up around 5 basis points to one-week highs.

The U.S. 10-year Treasury yield rose 7 basis points, with hawkish comments from Federal Reserve policymaker Charles Evans also buoying yields. The higher yields overshadowed the "flash" release of September eurozone inflation. Prices grew at 0.9%, below a forecast by economists polled by Reuters for 1%, and adding to concerns that ECB stimulus is doing little to revive inflation.

However, weak readings in individual eurozone countries over the last few days ensured expectations for the overall number had already been priced in, said Antoine Bouvet, a rates strategist at ING. He said the rise in bond yields on Tuesday did not reflect the fundamentals of a deteriorating outlook for the eurozone economy.

"There are still some adjustments that markets need to make to weaker economic indicators," he said, referring to poor Purchasing Managers' Index readings and linking Tuesday's higher bond yields to the Japanese government bond market selloff. On Tuesday, a September survey showed eurozone manufacturing activity had contracted at its steepest rate in almost seven years.

The widely watched 5-year, 5-year breakeven forward, a market gauge of eurozone inflation expectations, inched higher to 1.177% but remains close to its weakest level since July. Peter Chatwell, rates strategist at Mizuho Bank, said falling inflation expectations "should be something to worry about" and should be enough to "allow the market to firm up."

The benchmark 10-year German bond yield rose 5 basis points to -0.522%, while the 30-year yield was up 6 bps at -0.04%. Yields on Italian bonds, which have seen a dramatic contraction since August as investors welcomed the formation of a government deemed more fiscally responsible than the last, edged up slightly.

Analysts said the key focus this week is on the launch of the euro short-term rate ESTR, a new interbank lending rate that will be published for the first time on Wednesday, as the ECB ceases to publish EONIA, the current overnight benchmark.

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