Euro zone yields hit multi-week lows, core-periphery spreads tighten

By Stefano Rebaudo

Dec 7 (Reuters) - Euro zone borrowing costs fell on Wednesday amid expectations for inflation to peak soon while yield spreads between core and peripheral bonds tightened after data on Pandemic Emergency Purchase Programme (PEPP) reinvestments.

ECB Governing Council member Constantinos Herodotou said that rates were very near their "neutral level", while chief economist Philip Lane argued a peak in inflation was close.

Germany's 10-year government bond yield fell 4 basis points (bps) to its lowest since Sept. 19 at 1.75%.

"The strong pricing and demand at yesterday's Schatz tap add to the notion of overriding demand for Bunds in anticipation of peaking terminal rate expectations," Commerzbank analysts said.

The German Finance Agency sold 4.015 billion euros in a top-up of its 2.20%, 2-year Schatz notes at the lowest price of 100.17, with an average yield of 2.1%.

According to forwards on ECB Euro short-term rate (ESTR), rates will peak in June 2023 at around 2.75%. They priced a peak in August 2023 at around 2.9% at the end of November.

Italy's 10-year government bond yield fell 4.5 bps to 3.6% after hitting its lowest since August 26 at 3.58%.

The spread between Italian and German 10-year bond yields tightened to 182 bps. It hit its tightest since April 28 at 177.2 on Nov. 28.

The ECB cut holdings under its PEPP of southern European nations' bonds over the last two months, picking up German and Dutch debt instead, a bimonthly disclosure showed on Tuesday.

The ECB stopped buying new bonds under the PEPP earlier this year and said it would exercise "flexibility" when reinvesting cash from maturing debt, allowing it to help individual euro zone members should their borrowing costs rise too much.

"That (recent) tightening (between core and peripheral yield spreads) cannot be entirely explained by the rally in core rates and suggests instead genuine risk appetite for high beta fixed income," ING analysts said.

Some investors said recently that more attractive peripheral yields and a European Central Bank backstop could rein in the risk premium for Southern European debt.

Analysts said the lesson from the last five months of PEPP reinvestment data is that flexibility will remain a backstop for significant spread volatility episodes. Still, the ECB will use it sparingly and to the extent needed. (Reporting by Stefano Rebaudo; Editing by Toby Chopra)