EURO GOVT-Bund yields test 3.5 pct, have more room to rise

* Curve seen flattening further

* Bunds seen underperforming U.S. Treasuries for now

By Marius Zaharia

LONDON, April 11 (Reuters) – German Bund yields briefly rose
past 3.5 percent on Monday and looked to have room for more
gains as investors increasingly expect the European Central Bank
to hike interest rates again as soon as June.

The ECB has pointed markets towards further hikes this year
following Thursday’s increase, and investors have been shifting
the timing of the next one forward to June from July.

Bund yields have been on a sharp rising trend after bouncing
off the 38 percent retracement level of the 2008-2010 fall at
3.1 percent in mid-March, and the next target is seen at around
3.7 percent, which is the 62 percent retracement of that fall
and a June 2009 high.

“Any rally in the Bund will be sold for the moment unless
any shock comes out,” one trader said.

The Schatz yield (DE2YT=TWEB: Quote, Profile, Research) hit its highest since December
2008 at 1.944 percent, bringing the 2/10-year spread to 155
basis points. ING strategists see the spread tightening to 75
basis points in the next 12 months.

U.S. Treasuries have been outperforming Bunds recently, with
the yield spread between them (US10YT=TWEB: Quote, Profile, Research) (DE10YT=TWEB: Quote, Profile, Research) down
40 basis points from early-February to 10 basis points.

The spread has been below this level seven times over the
past six months and each time it has bounced above it
immediately. Some analysts say the spread can break below that
level soon and Bunds may underperform Treasuries for a good part
of this year.

“It (the Bund underperformance) can drag on quite a while,
given that obviously in the euro zone even after the ECB hike
inflation remains at the core of the discussion and this is not
going to change,” said Michael Leister, strategist at WestLB.

“Our call is that we are more likely to see ECB hikes by the
end of the year than Fed hikes.”

The longer-term trend, however, looks more favourable for
Bunds. DZ Bank strategist Glenn Marci expects Bund yields at 3.8
percent at the end of this year and at 4 percent over a 12-month
period and Treasury yields at 4 percent at the end of the year
and 4.3 percent over a 12-month period.

“There’s the expectation that if the Fed starts moving the
interest rate they have to hike quite quickly,” said Marci, who
expects the first hike in the U.S. in the first quarter of 2012.

Donal O’Mahony, global strategist at Davy Stockbrokers, said
the recent weakening of Bunds versus Treasuries may reverse in
the second part of the year as Federal Reserve officials turn
more hawkish, and comments following the Fed’s April meeting may
offer the first signs of that shift.

“As we move through the year you will see Fed policymakers
becoming more hawkish and that perhaps … is when
cross-Atlantic spreads will be widening again,” O’Mahony said.

The Bund future (FGBLc1: Quote, Profile, Research) was last 5 ticks lower at 119.99,
while 10-year yields (DE10YT=TWEB: Quote, Profile, Research) were 0.4 basis points higher
on the day at 3.493 percent, having hit their highest since
August 2009 at 3.501 percent earlier in the session.

BAILOUT

Portugal’s yields were steady with markets expecting details
about the terms of its bailout as officials from the European
Commission, the ECB and the International Monetary Fund readied
for talks in Lisbon on Tuesday on technical details.

Traders said Portuguese markets were likely to trade
sideways until the conditions of the aid deal are known. The
terms are key for assessing Portugal’s ability to stay clear of
a 2013 mechanism which will replace the current bailout fund and
have a preferred creditor status.

Investors believe chances are high that haircuts will be
imposed at least on holders of Greek debt from 2013.

Several euro zone finance ministers told Trichet they have
doubts Greece will meet its fiscal targets and suggested Athens
restructure its debt, a German magazine reported on Saturday.
[ID:nLDE738064]

Greek bonds were steady, but traders said tensions could
resume if talk about restructuring intensified.

“They are stating the obvious, but restructuring is not
something you would want to hear even if many already expect
significant haircuts,” another trader said.

By assuming investors will recover 40 percent of their
original investment, Davy Stockbrokers’ Donal O’Mahony says the
market is pricing in a 61 percent probability of a default based
on three-year CDS levels — currently at around 1,220 bps.

The annual cost of insuring 10 million euros worth of debt
over three years would be 1.22 million euros. This means
investors are paying an insurance rate of 61 percent to protect
against expected losses of 6 million euros.

(Editing by John Stonestreet)

EURO GOVT-Bund yields test 3.5 pct, have more room to rise