UPDATE 2-Coronavirus fears spark dash for safe-haven bonds, inflation expectations slide

(Recasts to capture moves across markets)

By Dhara Ranasinghe and Yoruk Bahceli

LONDON, Feb 28 (Reuters) – Safe-haven German government bond yields tumbled to five-month lows, Italian borrowing costs headed for their biggest weekly rise since August and a key gauge of long-term inflation expectations hit record lows as coronavirus panic swept through world markets.

Hopes that an epidemic that started in China would be short-lived, and that economic activity would quickly return to normal, were shattered this week as the number of international coronaries cases spiralled and Italy – one of the euro zone’s biggest economies – grappled to contain an outbreak.

Countries on three continents reported their first cases of the virus on Friday as the world prepared for a pandemic and investors dumped equities in expectation of a global recession, wiping $5 trillion off world share markets.

Uncertainty coupled with expectations that the coronavirus outbreak will force the hand of central banks to spark another day of hefty price action in bonds.

Germany’s benchmark 10-year Bund yield moved closer to last September’s record lows, the closely-watched Italian/German 10-year bond yield spread ballooned to its widest in six months and the U.S. two-year Treasury yield fell below 1% for the first time.

A key gauge of long-term euro zone inflation expectations hit a record low and euro zone money markets indicated investors were now positioning for a rate cut as early as June.

“There has been a very strong flight to quality and a growing expectation that this (coronavirus) is changing the macro landscape and increasing the need for policy action,” said Mark Dowding, chief investment officer at BlueBay Asset Management. “I don’t think markets have been helped by policymaker comments this week that it’s too early to take action. And markets will tend to be prone to panic at times that they feel policymakers are behind the curve.”

European Central Bank policymakers played down the prospect of immediate action to counter the economic impact of the coronavirus epidemic on Thursday.

Germany’s 10-year Bund yield fell to a five-month low of -0.62%. It is down 16 basis points this week and set for its biggest weekly drop since mid-2018.

The five-year, five-year breakeven inflation forward fell to a record low of 1.1157%.

Florian Hense, European economist at Berenberg, said slowing supply levels would drive inflation up rather than down, “but for the time being inflation expectations are very much looking at (the coronavirus) from a demand point of view,” Hense said.

“Our base case still remains that yes, this is a significant risk and hit to global activity, but we would still expect this to be temporary,” he said.

Italian government bond yields extended their rise after officials said Italy’s death toll had risen by five from Wednesday to 17. The number of people who tested positive for the illness increased by more than 200, to 650.

The outbreak could shunt Italy’s fragile economy into its fourth recession in 12 years.

The country’s 10-year bond yields rose as much as 13 basis points in early trade to 1.20%, the highest since Jan. 24 , and were last up 4 bps at 1.12%.

The gap between that yield and Germany’s 10-year government bond yield – a key measure of risk – touched 182 bps .

Spanish and Portuguese bonds underperformed, with the gap between their and Germany’s 10-year yields rising to the highest in nine months. .

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