March 27, 2018 / 7:51 AM / 4 months ago

UPDATE 3-Euro zone bond yields fall, inflation lag keeps hawks at bay

* Spanish inflation shoots below expectations

* ECB’s Liikanen flags low underlying inflation

* Italian politics, trade war concerns weigh

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds Makuch comments, updates prices)

By Abhinav Ramnarayan

LONDON, March 27 (Reuters) - Euro zone government bond yields fell on Tuesday after Spanish inflation undershot expectations and two European Central Bank policymakers flagged low underlying inflation as a reason to remain patient on policy tightening.

Governing Council member Erkki Liikanen said underlying euro zone inflation may remain lower than expected even if growth is robust, so the ECB needs to remain patient in removing stimulus.

Another member of the ECB’s Governing Council, Jozef Makuch, said underlying inflation in the euro zone has yet to show a convincing upward trend so the central bank needs to be cautious in its communication.

Initial estimates, meanwhile, showed that Spanish consumer prices rose by 1.3 percent in March, below the expected 1.5 percent.

The ECB’s target is for euro zone-wide inflation of just below 2 percent.

“The market was priced for higher Spanish inflation — this number feeds into the narrative that spot inflation is still very weak,” Mizuho strategist Antoine Bouvet said.

“Today’s news is confirmation of the theme we have talked about that tightening policy is constrained by the euro rally.”

The single currency has risen over 7 percent against the dollar since the start of November.

Euro zone government bond yields, which had edged higher in early trade, dropped across the board as the day wore on.

The yield on Germany’s 10-year government bond, the benchmark for the bloc, dropped to its lowest level in more than two months at 0.504 percent.

Southern European government bond yields, seen as key beneficiaries of loose monetary policy, were down 2-5 bps.

Earlier on Tuesday, the gap between Italian and Spanish 10-year borrowing costs reached its widest level in just over seven months in a market weighed down by Italian politics and the prospect of international trade protectionism.

The closely watched spread between the two peripheral countries’ debt — included in some market measures of political risk — moved to 67 basis points, its widest level since August 23, according to Thomson Reuters data.

Though the move proved short-lived, the milestone indicates that the market is jittery, analysts said.

“We have a lot of hopes that the U.S. and China will find a solution on the trade issue, but it is still like a sword of Damocles hanging over the market,” said DZ Bank analyst Sebastian Fellechner.

He said the risk of a coalition between Italy’s far-right League and the anti-establishment 5-Star has gone up after comments from the League on Monday that it was ready to talk to 5-Star about forming a government. (Reporting by Abhinav Ramnarayan Editing by Catherine Evans)

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