Periphery yields fall as deflation risk grabs attention away from Greece

LONDON: Yields on the euro zone's lowest-rated bonds dropped on Friday with deflation risks taking centre stage again after some reassurances from the new Greek government that it is looking for common ground with EU partners on its bailout.

Euro zone consumer prices are expected to have fallen by 0.5 percent year-on-year in January, compared with a 0.2 percent drop in December.

The risk of a prolonged period of growth-crippling deflation pushed the European Central Bank to launch an 18-month bond-buying programme worth over a trillion euros earlier this month, boosting demand for high-yielding assets.

Low inflation increases real-terms returns for debt investors and as long as the central bank buys bonds investors will be less concerned about the fact that some of the weaker countries need higher inflation to ease their debt burden.

The ECB scheme starts in March and can be extended, so the worse the deflation situation gets, the higher the expectation that the ECB would have to expand its quantitative easing programme, just like the Bank of Japan.

"There's an increased risk of a downside surprise (in inflation), which will clearly vindicate the ECB's decision to launch QE and highlights the deflationary pressure," said Nick Stamenkovic, a bond strategist at RIA Capital Markets.

"Any further signs that deflation is intensifying would clearly be a support."

Spanish and Italian 10-year yields were 4-5 basis points lower at 1.425 percent and 1.56 percent, respectively.

Greek 10-year yields fell 52 bps to 10.07 percent, while three-year yields fell 171 bps to 15.65 percent, but remained significantly higher than levels seen last week before Sunday's election. Peripheral bonds have been volatile this week, hurt by worries that the new Greek government led by anti-austerity Syriza party would enter a dangerous stand-off with other EU members over renegotiating the bailout deal.

But on Thursday, investors saw some green shoots of cooperation emerging. European parliament speaker Martin Schulz welcomed signs that the government was prepared to seek a joint solution with its lenders."In our eyes, these are the first signs of compromise," RBS said in a note. EU foreign ministers also won the support of Syriza to extend existing sanctions against Russia. Their position had been in doubt.