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Investors face nervous wait for ECB's final salvo of 2016

REFILE - CLARIFYING CURRENCY U.S. dollar and Euro notes are seen in this November 7, 2016 picture illustration. Picture taken November 7. REUTERS/Dado Ruvic/Illustration

By John Geddie

LONDON (Reuters) - Euro zone government bond yields crept higher as investors waited to see whether the European Central Bank would meet their high expectations for fresh stimulus at its final meeting of the year on Thursday.

The ECB is broadly expected to extend its asset purchase programme for at least another six months, and make tweaks to keep the 1.4 trillion euros ($1.5 trillion) scheme running smoothly.

But it remains to be seen whether the central bank will maintain its current 80-billion-euro monthly purchase rate, or send a token signal about the eventual end of quantitative easing (QE) in a concession to more conservative policymakers.

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A recent surge in long-term inflation expectations to a 12-month high, closing in on the ECB's near 2-percent target, and data showing business activity growing at its fastest pace in years, could influence the final decision.

This uncertainty has rekindled memories of the ECB's final meeting of 2015 which jolted markets after President Mario Draghi failed to live up to easing hopes, sending the euro on its biggest daily surge for nearly seven years.

"There is a long list of arguments for the ECB to reduce the pace of QE, and the market is not ready at all for that," Eric Oynoyan, European rates strategist at BNP Paribas, said.

"I think we could get the same kind of disappointment that we saw in 2015."

German 10-year government bond yields sneaked up 2 basis point (bps) to 0.37 percent, having briefly touched a near 11-month high of 0.40 percent in the early hours of Wednesday, according to Tradeweb data.

Most other euro zone yields were 2-3 bps higher on the day, and the euro hit a three-week high against the dollar. [FRX/]

WALK THE TALK

If the ECB extends purchases, as predicted by economists polled by Reuters, it will likely need to change some of the limits that currently restrain the programme.

The first of those is the possible removal of the lower yield limit for purchases - currently set at the ECB's deposit rate of minus 0.40 percent - which has at various points over the last year raised concerns that the central bank may run out of German bonds to buy, where the most purchases are centred.

It could also change or signal deviation from the model used to dictate how purchases are divided between countries, known as the capital key.

However, data shows this model has not been rigorously applied anyway due to restrictions in certain countries, so an increase to the volume of a country's debt and individual bonds may be more likely.

Calculations by Cantor Fitzgerald showed this week that without such changes, the ECB would run out of Irish bonds to buy in January.

In a sign of how politically sensitive this could be, the Irish Times on Wednesday ran the story headed: "Ireland faces ECB bond-buying guillotine if Draghi doesn't budge."

Finally, the ECB has signalled it is looking for ways to lend out more of its bonds to avert a squeeze in short-term funding markets known as repo markets, suggesting more attractive terms to its securities lending programme will be unveiled.

"The ECB will have to walk the talk this time and take decisive action on QE," Commerzbank analyst Michael Leister said.

($1 = 0.9268 euros)

(Editing by Ralph Boulton and Mark Potter)