UPDATE 1-Euro zone bonds show little reaction to negative inflation reading

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Recasts, adds details, comments)

By Yoruk Bahceli

AMSTERDAM, Sept 1 (Reuters) – Euro zone government bonds showed little reaction to a drop in inflation on Tuesday, with attention turning to what that might mean for the European Central Bank’s policy meeting next week.

Euro zone inflation turned negative in August for the first time since May 2016 at minus 0.2%. Underlying inflation, closely watched by the ECB, also tumbled, suggesting the bloc’s deepest recession is not temporary, but could prove to be a longer-lasting drag.

But that data evoked little market reaction, with some pointing to ECB board member Isabel Schnabel’s Reuters interview on Monday, where she said the bank had no reason for now to add to its stimulus measures.

Germany’s 10-year bond yield was last up 1 basis point to -0.39%, near its highest since early June, following the Fed’s announcement.

“Ultimately, how this reading today will impact markets will depend on whether it triggers an ECB reaction, and I think that is very unlikely at this stage,” said Piet Haines Christiansen, chief strategist at Danske Bank.

European inflation readings have been in the spotlight this week after the U.S. Federal Reserve announced last week that it would start to target an average of 2% inflation over a period of time rather than using the figure as a hard annual target.

That has steepened yield curves on both sides of the Atlantic, although many analysts think that effect is probably temporary, given uncertainty around whether inflation will actually rise.

Still, some analysts saw the disappointing inflation reading as supporting expectations that the ECB will eventually have to increase its bond purchases by the end of the year.

“Following these disappointing figures, pressure will likely mount for the ECB to increase its PEPP envelope by year-end in order to address investors’ concerns about low inflation,” said Christopher Dembik, head of macro analysis at Saxo Bank.

There was some optimism from Germany, where the economy minister confirmed that the government increased its 2020 forecast to a decline of 5.8% from a previous 6.3%.

In the primary market, Germany sold 327 million euros of inflation-linked bonds in an auction.

There was also focus on Sweden’s green bond, expected to price later on Tuesday, before Germany’s sale of its first-ever green bond, which analysts expect might be announced as early as today.

Elsewhere, Italian bond yields briefly rose to their highest in six weeks at around 1.17% in early trade, but were last down 1 basis points on the day to 1.15%. (Reporting by Yoruk Bahceli, editing by Larry King)

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