February 28, 2020 / 9:06 AM / in a month

UPDATE 3-Coronavirus fears spark dash for safe-haven bonds, inflation expectations slide

* Coronavirus (Updates prices, adds inflation charts)

By Dhara Ranasinghe and Yoruk Bahceli

LONDON, Feb 28 (Reuters) - Safe-haven German bond yields hit a five-month trough on Friday, Italian borrowing costs headed for their biggest weekly rise since October and a key gauge of long-term inflation expectations struck record lows as coronavirus panic swept through markets.

Hopes that an epidemic that started in China would be short-lived, and that economic activity would soon return to normal, were shattered this week as the number of international coronavirus cases spiralled and Italy - one of the euro zone’s biggest economies - grappled to contain an outbreak.

Countries on three continents reported their first cases of the virus on Friday as the world prepared for a pandemic and investors dumped equities in expectation of a global recession, wiping $5 trillion off world share markets.

Uncertainty coupled with expectations that the coronavirus outbreak will force the hand of central banks to spark another day of hefty price action in bonds.

Germany’s benchmark 10-year Bund yield moved closer to last September’s record lows, the closely watched Italian/German 10-year bond yield spread ballooned to its widest in six months and the U.S. two-year Treasury yield fell below 1% for the first time.

A key gauge of long-term euro zone inflation expectations hit a record low and euro zone money markets indicated investors were now positioning for a rate cut as early as June.

“There has been a very strong flight to quality and a growing expectation that this (coronavirus) is changing the macro landscape and increasing the need for policy action,” said Mark Dowding, chief investment officer at BlueBay Asset Management. “I don’t think markets have been helped by policymaker comments this week that it’s too early to take action. And markets will tend to be prone to panic at times that they feel policymakers are behind the curve.”

The European Central Bank does not need to take immediate action in response to the coronavirus epidemic, two ECB policymakers said on Friday, confounding market bets on a rate cut.

Germany’s 10-year Bund yield fell to a five-month low of -0.627%. It is down 16 basis points this week and set for its biggest weekly drop since mid-2018.

The five-year, five-year breakeven inflation forward hit a record low of 1.1157%.

Florian Hense, European economist at Berenberg, said slowing supply levels would drive inflation up rather than down, “but for the time being inflation expectations are very much looking at (the coronavirus) from a demand point of view,” Hense said.

“Our base case still remains that yes, this is a significant risk and hit to global activity, but we would still expect this to be temporary,” he said.

Rising rate-cut expectations helped limit the selloff in Italian bonds.

In late trade, Italy’s 10-year bond yield was up 2.5 bps at 1.09%, off one-month highs hit earlier at around 1.20%.

The coronavirus outbreak has hurt Italian bonds this week as concern grows that Italy’s fragile economy could now enter its fourth recession in 12 years.

Italian 10-year bond yields are still up 20 bps this week, set for the biggest weekly jump since October. The Italian/German 10-year yield gap - a key measure of risk - touched 182 bps earlier in the day.

Spanish and Portuguese bonds underperformed, with the gap between their and Germany’s 10-year yields rising to the highest in nine months. .

Reporting by Dhara Ranasinghe and Yoruk Bahceli; Editing by Kirsten Donovan and Susan Fenton

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