Wed Oct 16, 2013 6:55am EDT
* Bund yields hit new 3-week high on U.S. deal expectations
* German two-year bond auction strongly bid
* Market reaction to any deal seen limited
By Marius Zaharia
LONDON, Oct 16 (Reuters) - Safe-haven German Bunds fell on Wednesday, pushing yields to new three-week highs, as investors expected U.S. lawmakers to reach a last-minute deal to raise the debt ceiling and avoid a potential default.
After a day of stop-and-go negotiations, Senate leaders were said to be close to agreeing a debt deal that would also reopen the partially shut government. Earlier expectations that a deal could be announced late on Tuesday were not met.
The U.S. government is expected to hit its borrowing limit by Thursday. If a deal is not reached by then, default on government obligations could quickly follow, freezing the U.S. financial sector and threatening the global economy.
Bund futures, which usually find support in times of uncertainty as they are considered low-risk assets, were last 10 ticks lower at 139.14, while cash 10-year German yields hit fresh three-week highs at 1.926 percent.
They moved in line with U.S. 10-year T-notes, which were last up 2 basis points at 2.74 percent.
"(A U.S. default) is simply an event that is unimaginable for the market so that's why there's no panic even if we're 18 hours away from a possible Armageddon," DZ Bank strategist Christian Lenk said.
Analysts say markets are expecting a deal that would allow the U.S. to lift its debt limits enough so that politicians have a couple more months to find common ground on budget policies. They were not expecting a long-term fix.
"The deal people are expecting now is something that will at best push us to early 2014," Societe Generale rate strategist Ciaran O'Hagan said. "It might bring some pain relief but it will not be a multi-year grand fiscal bargain."
The impact of any deal on Bunds will be limited, he added, as the uncertainty during the budget negotiations has likely weighed on business sentiment, acting as a drag for the economy.
"The longer we're in limbo ...the more that's going to weigh on confidence," O'Hagan said.
SHAKY SHORT-TERM DEBT
While there was no sign of panic in global financial markets in broad terms, some areas were flashing red.
U.S. October T-bill yields traded above 0.50 percent, some 15-20 bps more than two-year yields, with traders saying investors were unwilling to accept them as collateral in funding markets. Investors would normally ask for a higher premium to hold longer maturities.
The cost to insure U.S. debt against default over one year via credit default swaps hit its highest since July 2011 at 75 bps, some 38 bps wider than five-year CDS, according to data from Markit.
Investors also used a two-year German bond auction as an opportunity to hedge against the so-called "tail risk" - a tiny possibility of a U.S. default.
Germany sold 4.24 billion euros of bonds at prices above those in the secondary market as demand measured by the bid/cover ratio rose to 2.3 from 1.6 at a previous auction.
"This is a strong auction result, with it likely having benefited from safe haven type demand on the back of the uncertainty about the political situation in the United States," Rabobank rate strategist Lyn Graham-Taylor said.
Other euro zone bonds were broadly steady.
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