Euro zone yields hit highest in weeks after Fed signals rate hike

By Abhinav Ramnarayan

LONDON (Reuters) - German bond yields hit their highest since early August on Thursday after policymakers in the United States signaled they expect to raise interest rates one more time this year and begin the "Great Unwinding" of a decade of aggressive stimulus.

The U.S. Federal Reserve said it would begin in October to reduce its approximately $4.2 trillion in holdings of U.S. Treasury bonds and mortgage-backed securities acquired in the years after the 2008 financial crisis.

"While the announcement that the balance sheet run-off will start in October was well flagged, the main surprise was the fact that the median path for next year shows three hikes," said ING strategist Martin Van Vliet.

The announcement pushed the yield on two-year Treasuries to its highest since November 2008, while those on 10-year debt hit a six-week high of 2.89 percent on Wednesday. Euro zone government bond yields followed suit on Thursday, rising as much as 3-5 bps across the board.

The yield on Germany's 10-year government bond, the benchmark for the region, rose to 0.50 percent, its highest since early August. It had pulled back by late trade to around 0.45 percent, still up around 2 bps on the day.

The gap between U.S. and German 10-year borrowing costs widened to 184 bps on Wednesday - its highest in a month - before tightening on Thursday.

Government bonds of the world's major developed economies tend to move together as many investors shift between them.

In addition, the European Central Bank is expected to take its cue from its U.S. counterpart and move towards tighter policy in the coming months.

European Central Bank President Mario Draghi said on Thursday monetary policy was not the right instrument to address financial imbalances in the euro zone.

Spain sold 4.7 billion euros of bonds on Thursday against a backdrop of political tensions between Madrid and Catalonia, as tens of thousands marched through the streets of Barcelona.

The protests came after Spanish police raided Catalan government offices and arrested officials on Wednesday to halt a banned referendum on independence.

Spanish government bonds, having underperformed on Wednesday, moved roughly in line with peers on Thursday, the 10-year yield rising 4 bps to top 1.50 percent.

"The central Spanish government's increasingly rigorous line of action in response to Catalonia's aspirations to independence triggered profit-taking on Spanish debt instruments, which subsequently spilled over to (Italian) BTPs," DZ Bank analyst Rene Abrecht said.

Greek bond yields rose 4 bps to 5.56 percent after Reuters reported late on Wednesday the country was considering swapping 20 small bond issues for four or five new ones as it prepares to exit its international bailout.

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; Additional reporting by Dhara Ranasinghe; Editing by Catherine Evans)

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