By Abhinav Ramnarayan and Saikat Chatterjee
LONDON (Reuters) - The euro's double-digit gains this year are prompting some of the world's biggest money managers to view European government debt more favourably just as the central bank is planning to withdraw its support from the bond market.
Euro zone government bond yields have risen steadily since September 2016, when speculation over a reduction in the European Central Bank's 2 trillion euro ($2.35 trillion) plus bond-purchase programme began. Investors worried a drop in official bond purchases would send yields soaring.
But some investors are considering another push into the market thanks to the currency's strength.
They say further euro gains could push back the ECB's plans to remove post-crisis monetary stimulus and make government bonds more attractive due to a combination of currency gains and policy support.
"Mainly because of the euro rebound, we couldn't afford to be short duration in government bonds, so we changed our stance in June," said Patrick Barbe, who heads the sovereign team at BNP Paribas Asset Management.
The fund manager, with 566 billion euros of assets under management, is one of the biggest investors in euro zone government debt and has shifted from a "negative" to a "neutral" stance on government bonds with longer duration.
Investors tend to buy longer-dated bonds if they expect interest rates to trend lower or remain on hold for an extended period.
The euro has gained more than 12 percent this year against the dollar and is the best performing currency in developed markets, with most of the gain coming in the last three months.
A strong euro reduces import prices and therefore keeps inflation lower in the bloc, making it harder for the ECB to tighten monetary policy and encouraging bond investors.
Analysts say a 1 percent rise in the euro's trade-weighted index shaves 0.3 to 0.5 percent off headline inflation.
While the ECB’s target is to boost inflation to "just below 2 percent", data for July shows inflation at just 1.3 percent.
Yields on German 10-year debt have fallen 20 basis points to 0.4 percent over the last four weeks as the euro's rally gained momentum.
"The euro's strength against the dollar over the last couple of months, since (ECB chief Mario) Draghi flagged a possible change to policy, will bring down the underlying inflation forecasts," said Brendan Lardner, a portfolio manager at State Street Global Advisor.
Draghi opened the door to tweaks in the bank's aggressive stimulus policy in a speech in Sintra, Portugal on June 27, fuelling expectations that the ECB will announce a reduction of stimulus this year.
In recent years, euro zone government bond yields have been compressed by extraordinary measures deployed by the ECB to boost an economy crippled by debt crises in 2010 and 2011, including deep rate cuts and aggressive bond purchases.
The ECB has bought more than 2 trillion euros of mainly government bonds and is nearing self-imposed limits in most bond markets. Total outstanding euro zone government debt stands at 7 trillion euros.
But with the euro zone economy recovering and a looming shortage of government bonds for the ECB to buy -- expectations were for the central bank to begin winding down these measures.
Market expectations were for the bank to announce the end of its bond-buying scheme in September and to hike rates twice in 2018.
In this environment, it looked like government debt, especially longer-dated bonds, would be the last place investors would park their money.
But the euro's rise has disrupted those expectations, particularly after the latest policy minutes from the ECB's last meeting in July showed policymakers were worried about a possible overshoot in the currency.
"If we see a rapid move up to $1.20-$1.22 area against the dollar, we would have more confidence in going tactically long duration, most likely in the 10-year euro zone government bond space," State Street’s Lardner said.
Money market futures suggest investors anticipate roughly a 60 percent chance of one quarter point rate hike from the ECB by the end of 2018. That is down sharply from earlier this month when a rate hike was fully priced in and last month when investors were expecting one as early as next June.
"We are a little bit underweight Germany compared to the U.S. because of the spread between the two but that would change if the euro keeps strengthening, particularly keeping in mind the pace of the move," said Seamus Mac Gorain, fixed income portfolio manager at JPMorgan Asset Management, which manages $1.7 trillion of assets.
He said that if the euro hits $1.25, it would make them more bullish on euro zone government bonds.
The effect could spread far beyond European shores as well. Daniel Loughney of AllianceBernstein, said he would consider buying the debt of other developed countries, whose bonds often move in tandem, if the euro strengthened further.
"The correlation between U.S. and German bonds is so strong that you can express the view on gilts and U.S. Treasuries and pick up the extra spread - or perhaps even Canada and Australia," he said.
($1 = 0.8505 euros)
(Editing by Philippa Fletcher)