July 14, 2020 / 11:23 AM / 25 days ago

UPDATE 2-Euro zone bond yields fall as markets turn cautious

* Euro zone yields 2-5 bps lower across the board

* California rolls back reopening plans

* U.S.-China relations worsen

* Italy sells 10 bln euros of debt

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds context)

By Abhinav Ramnarayan and Elizabeth Howcroft

LONDON, July 14 (Reuters) - Investors retreated to safe euro zone government bonds on Tuesday as U.S.-China tensions and new lockdown restrictions in California turned markets cautious, dampening Monday’s excitement over improved corporate earnings.

Equities fell after Californian Governor Gavin Newsom ordered renewed measures on Monday to stem the rise in COVID-19 infections in America’s most populous state, undoing weeks of reopening efforts.

Market sentiment also took a hit from worsening U.S.-China relations, after the United States rejected China’s claims to offshore resources in most of the South China Sea.

Most euro zone bond yields were about 2-5 basis points lower, with the 10-year Bund yield - the benchmark for the region - down around 4 basis point at -0.444%.

The fall cancels out some of Monday’s 6.3 bps rise, the biggest daily gain in over a month.

Riskier Southern European yields also fell, but to a lesser extent, with Italy’s 10-year government bond yield down 3 bps at 1.279%.

“The tightening trend in sovereign spreads has stopped. It hasn’t reversed but we’ve stabilized at current levels, which runs counter to the trend, runs counter to the impact of ECB intervention,” said Antoine Bouvet, senior rates strategist at ING.

Investors were focused on the European Central Bank (ECB) meeting on Thursday and EU summit set to start on Friday, at which leaders will discuss the proposed 750 billion euro coronavirus recovery fund.

German Chancellor Angela Merkel said on Monday she could not guarantee that EU member states would reach an agreement on the fund and a multi-year budget at the summit this week.

Further dampening expectations, Dutch Prime Minister Mark Rutte said on Tuesday he was pessimistic about the chances of a deal being reached.

Rutte has held a series of one-on-one discussions in recent days with EU leaders. They have been trying to persuade the Dutch to drop their opposition to the fund, which was first proposed by France and Germany.

Rabobank rates strategist Richard McGuire said that it was not so much the scale of the support the fund provides but whether or not there is any liability sharing that will determine the market reaction to the summit.

“From a market perspective, I don’t think it necessarily matters how much liabilities they’re sharing. It’s whether they’re willing to do so or not,” he said.

“If they’re unwilling to do so, that I think will be taken quite negatively,” he added.

McGuire also said that bond trading volumes were thin on Tuesday as markets enter an early summer lull.

“Investors will probably be hunkered down now given the potential for the developments – possibly notable developments – on Thursday and Friday, even though both of these may potentially be non-events,” he said.

Italy sold 10 billion euros of bonds due in 2023, 2027 and 2040 in an auction.

Reporting by Abhinav Ramnarayan and Elizabeth Howcroft; editing by John Stonestreet, Nick Macfie and Carmel Crimmins

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