Brexit pledge, ECB meeting temper euro zone bond rush

By John Geddie

LONDON (Reuters) - Euro zone bond yields bounced off two-week lows on Tuesday after Britain said it would hold a parliamentary vote on the terms of its exit from the European Union and focus shifted to a European Central Bank meeting that could shed light on divisions among policymakers.

British Prime Minister Theresa May said the government would put the final deal to a vote in both houses of parliament, a move that tempered concerns of a more aggressive exit that could do economic damage to Britain and continental Europe.

Bond yields in the euro zone were broadly in line with gilts, but as May's speech cleared some uncertainty, attention turned to Thursday's meeting of the bloc's central bankers.

So far this year, surprisingly strong economic data and rebounding inflation expectations in the euro zone have mainly occupied the minds of investors, raising doubts as to how long a divided ECB can keep monetary easing in full flow.

An ECB survey on Tuesday showed euro zone banks are set to ease credit standards in the first quarter after a modest tightening of corporate lending standards in the last three months of 2016.

Meanwhile, another survey showing German investor morale had improved, which could strengthen the case of a minority of policymakers who are calling for an end to money printing.

In December, the ECB extended its bond-purchase programme until late 2017, but with data from that month showing a sharp rise in inflation, German Finance Minister Wolfgang Schaeuble called for easing to be unwound.

And he is not alone. Minutes of the ECB's December meeting noted "a few members" rejected both proposals on the table to continue purchases beyond March.

"We expect that the ECB's preference will be to move to a 'wait and see' mode in the first half of this year to allow the package to work its way through the economy," RBC's global macro strategist Peter Schaffrik said.

"However, the reaction to December's euro area inflation data ... shows the challenge that (ECB) President (Mario) Draghi faces in holding to that line in coming months."

German 10-year bond yields fell 2 basis points (bps) to 0.24 percent, having hit a two-week low of 0.20 percent.

Analysts hope Draghi will also address the issue of German and French bond shortages that some say is undoing some of the ECB's own stimulus and raising questions about the functioning of the financial system.

The cost of borrowing those bonds has risen to record highs this month, threatening to deprive investment funds of the collateral they need to raise money and guarantee their trading positions.

Some analysts see the ECB's bond-for-cash scheme, begun in December to allow banks to borrow ECB holdings of government bonds in return for cash, as flawed because it only allows central banks to lend bonds at existing market rates.

Most other euro zone yields were down about 1 to 4 bps, with Spain, Portugal and Austria also pulling back from two-week lows after May's Brexit speech.

Peter Chatwell, a strategist at Mizuho, said Brexit would remain a key driver for bond markets in the months ahead.

"It's still going to be a destabilising factor going forward, if Brexit becomes more fractious. The ripples could be felt in the euro area for the next five years," he said.

Elsewhere, Italian bond yields rose after news that the European Commission has asked Italy to reduce its budget deficit this year and the country said it has hired banks for the syndicated issue of a new 15-year government bond.

(Additional reporting by Abhinav Ramnarayan; Editing by LLarry King)