By Ana Nicolaci da Costa
LONDON (Reuters) - Euro zone bonds rallied across the board on Thursday after the European Central Bank surprised markets by cutting interest rates to a new record low and said monetary policy would remain loose.
Short-dated German yields fell to multi-month lows and Italian yields hit a new five-month trough after the ECB cut rates by 25 basis points to 0.25 percent. The euro zone central bank said it could take borrowing costs lower yet to prevent an economic recovery from stalling as inflation tumbles.
All but one of 23 traders polled by Reuters this week had expected the ECB to keep rates steady, although many in the market thought it might signal a future cut.
"Inflation figures surprised recently on the downside and they wanted to react promptly in order to prevent the market from thinking too much about deflation risk," said Patrick Jacq, European rate strategist at BNP Paribas.
Data last month showed euro zone inflation unexpectedly dropped to a nearly four-year low in October.
Two-year German bond yields were 5 basis points lower at 0.09 percent, having hit a five-month low earlier at 0.05 percent. Five-year yields fell to their lowest since August.
Lower-rated debt outperformed, with Italian and Spanish yields seeing their biggest one-day fall in more than a month.
Ten-year Italian yields fell 9 basis points to 4.10 percent and the Spanish equivalent was 8 basis points lower at 4.07 percent.
Richard McGuire, senior fixed income strategist at Rabobank, said the ECB had provided a favorable backdrop for further narrowing in spreads between peripheral and safe-haven bonds.
The 10-year Spanish/German government bond yield gap could narrow as far as 200 bps from 238 bps currently, he said.
"Most people were caught off guard and the bullish impact of this surprise was heightened by the dovish tone of the accompanying press statement" McGuire added.
"I suspect the more likely recourse now would be for them to
cut the deposit rates into negative territory and/or provide an additional bout of liquidity via a new LTRO (long-term refinancing operation)." The latter was more likely, he added.
Policymakers were quick to praise the ECB's move, even though many analysts have questioned whether a rate cut would have any material impact on growth.
French Finance Minister Pierre Moscovici said the cut was good for the euro's fundamentals, while Italian Prime Minister Enrico Letta said the rate cut was "great news" and would help economic growth.
The jury was still out.
"It's not the solution by itself, it's just a support," Jacq added. "It can support growth as it's a signal that the ECB is doing everything to prevent deflationary risk.
"If consumers, if producers are expecting deflation, then growth is likely to be hit because they will not invest. So to some extent, it's a policy signal rather than having a technical impact," he added.
Yields on bonds issued by France, Austria, Belgium and the Netherlands also fell by around 6 basis points.
(Editing by Catherine Evans)