German yields hit new seven-week highs as euro zone recovers
* Euro zone economy grows 0.3 percent in second quarter
* German yields rise, Italian and Spanish yields fall
* Spain outperforms Italy after plan to reduce issuance
LONDON, Aug 14 (Reuters) - Germany's bond yields hit seven-week highs on Wednesday after data showed the euro zone had emerged from recession, with the reduced appetite for low-risk debt highlighted by a lacklustre Bund auction.
The better economic backdrop supported bonds issued by the currency bloc's weaker members, which need growth to service their large debts, and bond risk premia in Spain and Italy hit new two-year lows for the third consecutive day.
"Growth stories don't help Bunds, they help the periphery," said David Keeble, global head of fixed income strategy at Credit Agricole in New York.
"We are starting to see the periphery almost on a day-to-day basis setting two-year lows and that's just sucking demand away from Bunds... You don't need the safe havens like you once did."
The German 10-year debt sale attracted bids worth 1.3 times the amount allotted, below a 2013 average of 1.52 times even though the 1.8 percent yield at the auction was higher than this year's 1.47 percent average.
In secondary markets, 10-year German yields were flat at 1.81 percent, having earlier hit 1.84 percent, their highest since June 24. A move above 1.853 percent would take them to their highest levels since April last year.
Bund futures settled 9 ticks higher at 140.95 as investors tentatively returned to a cheapened market.
EURO ZONE GROWTH
The euro zone expanded 0.3 percent in the second quarter as growth in the bloc's two largest economies overshot forecasts. Germany grew by 0.7 percent, its fastest pace in more than a year, while French output rose 0.5 percent.
Investors expect the economic recovery to continue, said Padhraic Garvey, head of investment grade strategy at ING, pointing to the shape of the German yield curve. At 160 bps, the 2/10-year yield gap was at its widest since July 8.
"The fact that the curve has steepened out reflects that ... the expectations with regards to nominal growth have improved," he said. "I think ... we continue to steepen for as long as rates are really anchored at the front end."
Garvey said the European Central Bank's promise to keep interest rates at record lows until further notice limited the scope for moves in the two-year German yield.
Anticipation of better data has been a factor behind recent falls in the yield premia offered by Spanish and Italian 10-year bonds over Bunds. Both hit fresh two-year lows at 260 bps and 235 bps, respectively.
Outright Spanish 10-year yields fell 6 bps to 4.42 percent, faster than their Italian counterparts, which dipped 2 bps to 4.18 percent. With the two countries already 70-80 percent funded for year, Spain said on Tuesday it would slow the pace of bond issuance in coming months, while Italy said it will stick to the plan.
"(Funding progress) is still a very beneficial feature of both markets... (but) the Spanish comments ... were very nice to hear," Commerzbank rate strategist David Schnautz said.
In Portugal, where the economy grew 1.1 percent in the second quarter after a 0.4 percent contraction in the previous three months, 10-year yields fell a modest 4 bps to 6.60 percent.