Dovish Yellen brings comfort to peripheral bond markets

By Dhara Ranasinghe

LONDON (Reuters) - Peripheral bonds led euro zone yields down on Tuesday as dovish comments from Federal Reserve Chair Janet Yellen bought some solace to risk markets that have started to become unnerved by a looming referendum in Britain on European Union membership.

In a speech on Monday, Yellen gave a largely upbeat assessment of the U.S. economic outlook and said interest rate hikes were coming, but gave little sense of when.

Those remarks boosted European shares and demand for lower-rated or riskier bonds in southern Europe.

Italian, Spanish and Portuguese bond yields fell around 3-5 basis points, unwinding the previous day's rises.

"Fed Chair Yellen's latest dovishly interpreted speech is supporting risk markets," said Nick Stamenkovic, macro strategist at RIA Capital Markets.

Data showing the euro zone economy grew by 0.6 percent in the first quarter of 2016, the highest rate for 12 months, and German industrial output rose slightly more than expected in April, helped boost risk appetite.

On Monday, Italian bond yields notched up their biggest one-day rise in six weeks and Portuguese yields hit a three-week high as concern that Britain might leave the EU and a setback for Italy's government in municipal elections at the weekend brought political risks to the fore.

Peripheral bond markets are seen particularly vulnerable to Brexit risks, partly because lower-rated debt markets tend to suffer more during bouts of risk aversion.

"For a long time it seemed that markets were relaxed about Brexit risks and volatility was low and that is changing as the "Leave" campaign gains momentum and means anything that is seen as a risk asset is vulnerable," said DZ Bank strategist Daniel Lenz.

In a sign that markets are starting to price in the risk of Britain leaving the EU, the yield gap between southern European and top-rated German bonds has started to widen.

Portuguese 10-year yield spreads are near their widest level in about a month, while the Spanish/German yield gap is close to its widest in about three weeks.

Analysts say Brexit jitters and the European Central Bank's asset purchases should bolster safe-haven German bonds.

German 10-year Bund yields were steady at 0.08 percent, near Friday's more than one-year low of 0.065 percent.

Data on Monday showed the ECB, faced with a scarcity of bonds for its bond buying programme, bought more German, French and Italian bonds than its rules dictate in May.

The average yield of German bonds in circulation dipped to minus 0.02 percent on Monday, falling below zero for the first time, data from the German Bundesbank also showed on Monday.

"We have a safety bid for German bonds right now and the ECB's asset buying is compounding downward pressure on bond yields," said Rainer Guntermann, a strategist at Commerzbank.

(Reporting by Dhara Ranasinghe; Editing by Andrew Heavens and Angus MacSwan)