* Hungarian bond yields continue to retreat
* Global, euro zone risk aversion hits CEE equities
* Warsaw stocks test 21-month lows, led by PKN Orlen
* Does stocks sell-off signal EU slowdown or not ?
By Sandor Peto and Alicja Ptak
BUDAPEST/WARSAW, Oct 26 (Reuters) - Hungarian government bonds extended their gains on Friday helped by technical factors and liquidity from coupon payments and expiries, despite a sell-off in risky assets in European markets.
Central European stock indices followed euro zone peers lower as investors preferred safe German debt over equities, partly due to fear that S&P may downgrade Italy which has drawn criticism by increasing its budget deficit target for 2019.
Citigroup said in a note that the bonds of Hungary, which has the lowest central bank interest rates in the region, were particularly vulnerable to a spread widening in Italian bonds
Hungarian bond yields still dropped by 2-3 basis points on Friday, tracking Bunds, with the 10-year paper trading at 3.68 percent, while Italy’s corresponding yield was bid higher by 2 basis points at 3.52 percent.
Polish yields, which tended to track Bunds in the past months, were flat this time after an auction of government bonds in Warsaw.
“The Hungarian market has been underperforming in the past three months and technical factors point towards lower yields now,” one Budapest-based fixed income trader said.
“Also (short-term) Treasury bill yields are amazingly low, while there are coupon payments and expiries,” the trader added.
Earlier this month, after a rise in U.S. debt yields, the spread between Hungary’s 3-month bill an 10-year government bond yields widened to about 4 percent, a record in at least 14 years.
Strong demand at the bond auctions Hungary held on Thursday showed that the recent yield rise made long-term Hungarian bonds attractive, traders said.
Government bond yields were mixed in the region, and did not track a rise in the average yield on emerging markets debt .
But the forint and the zloty followed the MSCI emerging market currencies index lower, shedding 0.1 percent against the euro by 0935 GMT.
In stock markets, also Warsaw and Budapest led a decline.
Warsaw’s bluechip index fell 1.8 percent, almost as much as Frankfurt.
It set a 4-month low and tested 21-month lows, led by high-capitalized oil group PKN Orlen. A dealer said the international sentiment caused the fall rather than local factors or news.
Warsaw, by far the biggest equities market in Central Europe, has heavily underperformed the region this year.
Shedding 20 percent since its January peak, it lost the equivalent of 8 percent of Poland’s economic output in capitalization, tightening financial conditions, KBC analysts said in a note.
But real interest rates have much bigger impact on the economy, which means central banks are unlikely to react to the recent sell-off, they added.
“On the other hand, should the recent global equity sell-off indicate that business activity in Western Europe has been really slowing..., then Central Europe should take the whole story more seriously,” KBC said. (Reporting by Sandor Peto; Editing by Richard Balmforth)