November 16, 2018 / 12:12 PM / a month ago

UPDATE 2-Euro zone bond yields creep up but Brexit and Draghi limit rise

* Euro area bond yields creep up, Brexit remains in focus

* German Bund yields down 4 bps this week

* Draghi raises prospect of slower inflation

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds Italy budget update, bond yield move)

By Dhara Ranasinghe

LONDON, Nov 16 (Reuters) - Euro zone government bond yields nudged up on Friday as some stability returned to British markets following the previous day’s Brexit-driven turmoil.

Generally dovish comments from European Central Bank chief Mario Draghi on the inflation outlook helped support regional bond markets.

Ten-year borrowing costs in the bloc’s benchmark issuer, Germany, were set for their biggest weekly fall in three weeks, a sign that uncertainty in Britain and Italy continued to bolster demand for safe-haven assets.

Sterling recovered on reports that a leading eurosceptic minister would not follow other Brexiteers in quitting the British government and as Prime Minister Theresa May struck a defiant tone despite strong opposition to her Brexit deal.

Still, an uncertain backdrop meant a rise in bond yields in countries including Germany and France was limited, especially ahead of a weekend when most investors tend to favour holding safer assets in case of a negative surprise, analysts said.

“Given the political uncertainty in the UK, investors are still worried about how things could play out and will remain interested in the safe-haven qualities of higher-rated government bonds,” said an analyst at a German bank who asked not to be named.

Most 10-year euro zone bond yields were marginally higher on the day. Germany’s 10-year bond yield was up about a basis point at 0.37 percent - above more than two-week lows of around 0.35 percent hit on Thursday as Brexit turmoil triggered the biggest one-day fall in 10-year gilt yields since just after the 2016 Brexit vote.

British gilt yields are down nine bps this week, while German Bund yields are four basis points lower.

Italian bond yields had initially fallen about 6-7 bps on Friday , benefiting from a recovery in risk appetite and signs this week of a more conciliatory tone from Rome on the contentious 2019 budget.

However, this rally was cancelled out after a report the European Commission will move next week to discipline Italy over its 2019 budget, officials close to the process said on Friday.

Italy’s 10-year bond yield was flat again by 1600 GMT at 2.49 percent, having dipped as low as 2.41 percent earlier in the session. The spread over Germany was slightly tighter on the day at 312 bps but still close to its recent wide levels.

“This to and fro between the EU and Italy will continue,” said Salman Ahmed, chief investment strategist at Lombard Odier in London.

“But the fact remains that Italy is not doing something system-destroying, it’s not like they went for a 5-6 percent (budget deficit). It was within the scope of EU rules so I do expect some compromise and I think a penalty will be an extreme step,” he added.

Higher returns on Italian debt are expected to attract healthy demand from Italian savers for a new “BTP Italia” bond on offer next week, a test of retail support for the Treasury’s mounting refinancing needs.

TIME FOR DRAGHI

The ECB still plans to dial back stimulus at the end of the year, but inflation may rise more slowly than earlier expected, Draghi said.

Euro zone bond yields briefly rose as Draghi described the economic cycle as “resilient”, but the overall tone of his remarks was dovish, analysts said.

Draghi cautioned that an undue rise in borrowing costs would change the path for rates, hinting at a spillover from the United States or ripple effects from Italy as possible reasons.

“Draghi at least just sent a clear signal of the ECB’s willingness to err on the side of caution when it comes to the first rate hike,” said Carsten Brzeski, chief economist at ING Germany.

“The risk that Draghi could go down in European history books as the first ECB president who never hikes rate is increasing.”

Reporting by Dhara Ranasinghe and Sujata Rao; editing by Andrew Roche

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