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Spanish CPI shock flags euro deflation risks

The euro and benchmark German bond yields slid to three-week lows on Friday as a surprise fall in Spanish inflation bolstered investors' bets the European Central Bank will ease policy next week to ward off the threat of deflation.

Equity markets drew support from the renewed potential for looser ECB monetary policy, as well as reports Beijing could fast-track infrastructure spending to boost the Chinese economy.

Angel Navarrete | Bloomberg | Getty Images

The 0.2 percent annual decline in Spanish consumer prices this month was larger than expected, the weakest figure since October 2009, and enough to push Spanish 10-year government bond yields to a new eight-year low.

Preliminary German inflation data for March later on Friday will now come under even greater scrutiny for signs that the threat of deflation is spreading from peripheral euro zone economies like Spain to the bloc's powerful core.

"The market is reacting strongly, and this really indicates that the market is nervous," said Michael Leister, rates strategist at Commerzbank in London.

(Read more: ECB to get drastic? QE could be on the table)

"The bar is very high for further ECB easing, and we think the ECB is still going to stay on hold. But this is going to underpin these easing expectations," he said.

The euro hit a three-week low of $1.3704, falling further back from the $1.40 level many analysts think would be too strong for the fragile euro zone economy in the eyes of ECB policymakers.

Germany's 10-year Bund yield fell to 1.52 percent, while Spanish and Italian yields fell to eight-year troughs of 3.22 percent and 3.27 percent, respectively.

The ECB sets policy on Thursday next week, when it will have the euro zone-wide flash inflation estimate for March due on Monday. Economists expect that to slip to just 0.6 percent, well below the ECB's target of below but close to 2 percent.

Europe's main equity markets were all higher, posting early gains of up to three quarters of one percent.

The FTSE Eurofirst 300 index was up 0.7 percent at 1332 points, on for its fourth straight day of gains as investors square positions at the end of the quarter.

After the respective eight and six percent gains of the previous two quarters, equity investors have been much more cautious in the first three months of the year. The FTSE Eurofirst 300 is on track for a gain of around 1 percent.

China boost?

Asian and emerging market shares were supported by comments from China's Premier Li Keqiang, who was quoted by state media as saying the government would roll out targeted measures step-by-step to aid the economy.

MSCI's index of Asia-Pacific shares outside Japan added 0.7 percent and Japan's Nikkei .N225 closed at a three-week high of 14,696 points ahead of the end of their financial year on March 31.

Emerging markets showed signs of recovering from a bruising few weeks, with hopes of further Chinese stimulus pushing with the military and geopolitical tensions surrounding Russia and Ukraine further into the background.

The MSCI index of emerging shares has climbed for six straight sessions to the highest since January 3. The index for Latin America on Thursday boasted its biggest daily gain since July 2012 as Brazilian markets rallied.

In U.S. bond markets, Treasury yields were capped by the fall in European bond yields. Ten-year U.S. borrowing costs hovered around 2.67 percent, a single basis point above Thursday's 11-day low.

Gold looked to snap its broad losing streak this month, rebounding from Thursday's six-week low to trade up 0.4 percent on the day at $1,295.00 an ounce.

In the oil market, U.S. crude futures were almost flat on the day at $101.43 a barrel.

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