Euro zone bonds inch higher on ECB policy easing bets


* Low inflation puts pressure on ECB to ease policy

* Euro zone bond yields fall broadly

* Yield curves steepen as short-term yields fall more

By Emelia Sithole-Matarise and Marius Zaharia

LONDON, Nov 1 (Reuters) - Euro zone bonds broadly edgedhigher on Friday, extending this week's rise after asurprisingly sharp slowdown in euro zone inflation raisedexpectations that the European Central Bank may ease monetarypolicy further.

October inflation fell to 0.7 percent from 1.1 percent theprevious month, well below the ECB's target of just under 2percent, data on Thursday showed. The shock was so great that itovershadowed a Federal Reserve statement that was perceived asless dovish than anticipated.

Short-term euro zone inflation gauges as measured by Frenchbreakeven rates, the yield spread between euro zoneinflation-protected government bonds and equivalent nominaldebt, have plumbed to July lows since the report.

Many in the market expect the ECB at least to signal a ratecut or new liquidity injections at its meeting next week, whileholding fire until December when it will have updatedmedium-term inflation and growth forecasts.

"Inflation is so low that you just have to assume they'll dosomething about it," said Alan McQuaid, chief economist atMerrion Stockbrokers. "That's going to keep the (bond) marketswell bid going into the ECB meeting."

Shorter-dated bond yields, more sensitive to central bankpolicy than the longer-dated ones, fell the most.

Two-year Spanish yields fell 6 basis points to1.09 percent, while equivalent Italian yields dropped 5 bps to 1.39 percent. Their 10-year counterparts fellby 2 bps to 4.02 and 4.11 percent,respectively.


In core euro zone bonds, German two-year yields, were 1 bp lower at 0.11 percent, their lowestsince Aug. 1, steepening the 2- to 10-year yield curve by 3 bpsto 158 bps. Bund futures closed 15 ticks lower at141.85, having hit a two-month peak of 142.32 on Thursday.

Longer-dated Bunds tend to track their top-rated peers, theU.S. Treasuries, more closely and therefore the Fed outlook hasmore influence on them.

A stronger-than-expected report on U.S. manufacturingreduced pessimism about the economic recovery, reviving someworries the Federal Reserve might pare its bond purchasesearlier than some traders had thought.

"The market is now strongly expecting the ECB to deliversomething by the December meeting so the front end is extremelywell bid," a trader said. "Longer-dated Bunds to some degree aregoing to trade with a bit of a bias towards what Treasuries willdo after the Fed was not so dovish."

The ECB has not sent any official signals of imminent easingsince its October meeting and were it to make such a move, it isunclear whether it would opt to cut rates or prefer to givebanks another dose of cheap long-term loans.

Societe Generale strategists said in a note they expectedthe central bank to cut interest rates to a record low 0.25percent from the current 0.50 percent in December.

"From the ECB perspective, a key rate cut would weigh on theeuro/dollar near term and help anchor inflation expectationsthat otherwise could drop sharply," they said.

"However, it is doubtful that a rate cut alone would have alasting effect on the euro exchange rate and an LTRO (programmeof cheap loans) would probably have a bigger effect."

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