February 22, 2017 / 8:53 AM / 6 months ago

German-U.S. bond yield gulf last seen at dawn of millennium

* Germany's two-year bond yield drops to record low

* U.S. equivalent sneaks up ahead of Fed minutes

* Gap between the two benchmarks widest in 17 years

* Spanish yields rise as country sells 15-year debt

By John Geddie

LONDON, Feb 22 (Reuters) - The gap between short-dated German and U.S. government bond yields stood at its widest in nearly 17 years on Wednesday as the former fell to record lows and the latter nudged up in anticipation of rate increase signals.

In a move seemingly out of kilter with broader moves in euro zone bond markets, German two-year yields dropped to a record low of minus 0.88 percent on Wednesday.

Analysts said jitters around upcoming French elections have stoked demand for an asset seen as one of the safest in the euro zone. Bottlenecks caused by the European Central Bank's bond-buying programme and upcoming regulatory changes have amplified the decline the yields, which move inversely to prices.

U.S two-year yields have been sneaking higher in recent days, reaching 1.24 percent -- within sight of a seven-year high breached at the end of 2016 -- as investors start to price in an outside chance the Federal Reserve will raise interest rates next month.

The two-year's yield is some 212 basis points above its German equivalent, the biggest gap since early 2000.

U.S. Federal Reserve Chair Janet Yellen said last week a rate increase in the world's largest economy would be considered at every policy meeting. Wednesday's release of the minutes of the central bank's last meeting are expected to provide more clues on the timing.

Money markets suggest a roughly one in five chance the Fed will raise rates at its meeting next month, according to CME's FedWatch tool. Some banks call it as high as a 40 percent chance.

Philadelphia Fed President Patrick Harker on Tuesday said he would support a rate increase at a mid-March policy meeting as long as inflation, output and other data continue to show a growing U.S. economy.

"There are a host of special factors driving two-year German bond yields lower and on the other side of the Atlantic we have the Fed contemplating another hike, which is driving up U.S. equivalents," ING strategist Martin van Vliet said.

Elsewhere in the euro area, investors sold Spanish and other low-rated bonds on Wednesday to make room in their portfolios for new 15-year debt that Madrid is selling.

Spain has already gathered more than 11.5 billion euros of indications of interest in its new deal, according to IFR, and is expected to price the bond later on Wednesday.

Spanish, Italian and Portuguese bond yields all edged up around 3 basis points to 1.70 percent, 2.25 percent and 4.07 percent, respectively.

This stretched the gap to benchmark the German equivalents, which were flat at 0.31 percent. Berlin is also scheduled to sell 30-year debt at an auction on Wednesday.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets

Editing by Larry King

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