UPDATE 3-Euro zone bond markets calm as inflation surges past ECB target

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

LONDON, June 1 (Reuters) – Most euro zone government bond markets were broadly steady on Tuesday, looking past a surge in inflation in the currency bloc to the likelihood that hefty monetary stimulus will remain in place for some time.

Italy’s 10-year bond yield reached an over three-week low in a sign markets were confident the European Central Bank will not decide to slow the pace of bond buys when it meets on June 10.

Data showed inflation in the 19 countries sharing the euro rose to 2% in May from 1.6% in April, driven by higher energy costs to its fastest rate since late 2018 and above the ECB’s aim of “below but close to 2%”.

In addition, IHS Markit’s final Manufacturing Purchasing Managers’ Index (PMI) rose to 63.1 in May from April’s 62.9, above an initial 62.8 “flash” estimate and the highest reading since the survey began in June 1997.

The ECB has stressed a near-term rise in inflation is driven by one-off factors and long-term price pressures remain subdued, meaning stimulus will still be needed.

That may help explain the muted reaction to the data in bond markets, where yields have fallen in the past week amid dovish comments from a slew of ECB officials.

“The proximity to the ECB meeting is shielding euro zone rates from the fallout of higher CPI and higher PMIs this morning,” said ING senior rates strategist Antoine Bouvet.

“This is short-sighted I think and the rate rises should resume after the pre-ECB pause.”

Germany’s benchmark 10-year Bund yield was steady at around -0.18%, but holding below last month’s two-year highs. Most other 10-year euro zone bond yields were little changed on the day.

Italy’s 10-year bond yield extended recent falls to hit its lowest level since May 7. It was last down around 1.3 bps at 0.903%.

“German Bund yields briefly rose then fell back immediately after the flash CPI data and what this tells me is that markets see no risk of tapering at next week’s ECB meeting,” said Saxo Bank strategist Althea Spinozzi, explaining the move in Italian yields.

“And the biggest beneficiary of that is Italian bonds.”

Economic recovery prospects in the euro zone remain uncertain and the ECB will counter any strong rises in interest rates that are not justified by economic conditions, governing council member Ignazio Visco said on Monday.

Elsewhere, the five-year breakeven forward, a key gauge of the market’s long-term euro zone inflation expectations, rose to 1.61%, its highest in nearly two weeks as oil prices topped $70 . It was last just below 1.6%.

In issuance news, the European Commission said it would borrow about 80 billion euros of long-term bonds this year to finance the 750 billion euro NextGenerationEU fund to support the recovery. Borrowing will begin later this month.

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