December 6, 2017 / 9:13 AM / in 12 days

Euro zone bond yields drop on U.S. tensions, flattening yield curve

* German 10-year yields close to 3-month lows at 0.295 pct

* Trader says U.S. tensions are boosting demand for safe assets

* Most high-grade euro zone yields lower 1-2 bps

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr

By Fanny Potkin

LONDON, Dec 6 (Reuters) - German 10-year government bond yields were close to three months lows on Wednesday, pushed down by political tension in the United States and a continued flattening of the U.S. Treasury yield curve.

Concerns over progress of a tax reform bill and a U.S. federal investigation into Russian interference in the 2016 presidential election have added to market uncertainty.

Adding another layer to this, U.S. President Donald Trump is to announce on Wednesday that the U.S. recognises Jerusalem as the capital of Israel and will move its embassy there, breaking with longtime U.S. policy and potentially stirring unrest.

Traders said all of this was boosting demand for German bonds, considered one of the safest financial assets in the world, as well as other well-rated euro zone government debt.

DZ Bank strategist René Albrecht, for example, said the drop in euro zone yields - yields move inversely to price - was due to this “risk off sentiment” related to U.S. policy uncertainty.

“There’s three relevant factors in the United States for this: the tax bill, political tensions, and the postponement of the U.S. debt ceiling and the risk of a government shutdown on Saturday,” he said.

Congress has a notional Dec. 8 deadline to raise the debt ceiling, but the U.S. Treasury can take emergency measures to delay the drop-dead date.

German 10-year bond yields were near a three month low, hitting 0.295 percent in early trade, down 2 basis points on the day.

Other high grade euro zone bond yields were lower by 1-2 bps.

U.S. Treasury yields have dropped sharply this week, falling 9 basis points from Monday’s high of 2.42 percent, and the gap between 2-year and 10-year borrowing costs is at or close to its narrowest level in a decade.

The focus could switch back to the euro zone later on Wednesday with European Central Bank board member Yves Mersch due to speak at a conference, and the European Commission set to unveil its proposal for how to reform the bloc.

The fall in German bond yields comes despite the fact that the country’s debt management agency is to sell 10-year bonds for 2 billion euros later on Wednesday.

Normally, yields rise ahead of auctions as investors sell outstanding bonds to make space for the new sale.

Portugal will conduct a bond exchange whereby it will offer investors bonds seven-year and 10-year bonds in exchange for the country’s outstanding debt maturing in 2019 and 2020.

Later on Wednesday, ADP figures that detail U.S labour market data will give an indication of employment trends in the world’s biggest economy ahead of the key non-farm payroll numbers due on Friday.

The numbers will be closely watched, with the U.S. Federal Reserve largely expected to hike rates at next week’s policy meeting.

German industrial orders increased unexpectedly in October thanks to domestic and non-euro zone demand, data showed on Wednesday, suggesting this sector of Europe’s biggest economy is likely to gain steam in the coming months.

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

Reporting by Abhinav Ramnarayan; Editing by Alison Williams

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