October 5, 2016 / 8:31 AM / 10 months ago

UPDATE 1-Euro zone bond markets spooked by taper talk

4 Min Read

* Bloomberg report on ECB plan for winding down QE rattles markets

* Bond yields rise to two-week highs

* Analysts say further QE extension likely

* But mere notion of "tapering" unsettling investors (Writes through)

By Dhara Ranasinghe

LONDON, Oct 5 (Reuters) - Most euro zone bond yields rose to two-week highs on Wednesday, with investors on edge a day after a media report served as a reminder that the European Central Bank's massive asset purchases will eventually be wound down.

The ECB has not discussed reducing the pace of its monthly bond buying, a central bank media officer tweeted late on Tuesday in response to a Bloomberg article that cited sources as saying the ECB would probably wind down its bond buying gradually before ending quantitative easing.

While many analysts still expect the ECB to extend its 1.7 trillion euro programme beyond March next year as is currently planned, the mere notion that bond buying will one day come to an end was enough to spook global bond markets.

The talk of a potential "tapering" of QE comes at a time when investors are questioning whether central banks are winning the battle to boost growth and inflation, and whether governments should do more of the heavy lifting.

"I am surprised at the reaction, but it's just this notion that the ECB may be discussing tapering one day that has upset the market," said ING rates strategist Benjamin Schroeder. "If you kick off a QE programme you have to think from the start about how you will exit it."

Euro zone bond yields rose sharply for a second straight day, with benchmark German 10-year Bund yields hitting a two-week high at minus 0.040 percent -- taking its increases over the last two sessions to almost 6 basis points.

U.S. and Japanese bonds yields have been dragged higher, while the euro extended its bounce.

ECB asset purchases, launched early last year, have been a key driver of lower bond yields across the euro zone - helping drive benchmark German bond yields into negative territory and anchor borrowing costs in lower-rated countries such as Portugal and Italy at times of volatility.

In a weekly note, analysts at Bank of America Merrill Lynch said market speculation about ECB tapering had dominated conversations with clients.

Comments from ECB officials in recent weeks suggesting the central bank is in no immediate hurry to address a scarcity of eligible bonds for QE or extend the programme has added to a sense that ECB policy action is nearing the end of its effectiveness.

Inflation in the euro zone is just 0.4 percent, well below the ECB's target of close to but below 2 percent.

Following September's policy meeting, ECB chief Mario Draghi said the central bank had not discussed extending asset purchases, sparking a sell-off in bond markets.

"Fundamentally there's no reason to taper as they are not close to achieving their inflation mandate," said Patrick O'Donnell, an investment manager at Aberdeen Asset Management.

"The reason you would taper is if you feel the policy is not working or the negative effects outweigh the positive effects of the policy."

Low bond yields and a narrow gap between long- and short-dated yields hurts banks' profitability, and the euro zone banking sector is struggling.

Across the euro zone, 10-year yields were 3-6 bps higher on the day with Dutch, Finnish, Spanish and Italian yields also hitting their highest levels in around two weeks.

Germany is scheduled to sell four billion euros of 10-year bonds later in the day. (Reporting by Dhara Ranasinghe; Editing by Toby Chopra)

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