Tue Oct 14, 2014 6:39am EDT
* Germany's ZEW turns negative for first time since 2012
* QE hopes cushion the blow for Spain, Italy
* ECB bond-buying faces challenge in top court
* Greek yields break 7 pct amid political worries
* Catalonia calls off scheduled referendum (New throughout)
By John Geddie
LONDON, Oct 14 (Reuters) - German government bond yields hit a new record low on Tuesday as a monthly gauge of economic sentiment reinforced fears the euro zone's engine may be slipping towards recession.
The ZEW institute's index of German economic sentiment turned negative for the first time since late 2012, falling to -3.6 in October from 6.9 the previous month. Economists polled by Reuters had expected a reading of 1.
Speaking after the release, ZEW's chief economist said the German economy could shrink in the third quarter, taking it into recession after a contraction of 0.2 percent in April-June.
Europe's malaise is fuelling concerns around global growth, pushing investors towards safe-haven assets, but the impact on some of the euro zone's riskiest government debt has been limited by expectations of further European Central Bank easing.
"Economic concerns are so much in focus now that the risk-off sentiment is more dominant currently than the QE (quantitative easing) effect," DZ Bank strategist Daniel Lenz said, referring to expectations among investors that the ECB will launch a scheme to buy sovereign bonds with new money.
Ten-year German bond yields dipped 4 bps to a new record low of 0.847 percent after the ZEW reading, while Italian and Spanish equivalents each rose 1 bp to 2.34 and 2.09 percent. Lenz said that if QE was not anticipated, yields in Spain and Italy would be 6-7 bps higher.
But hopes for a sovereign bond-buying scheme could be dealt a blow by Europe's top court, which opens discussions on the legality of any such scheme on Tuesday.
After a referral by Germany's Constitutional Court, the European Court of Justice will hear challenges from German plaintiffs to the ECB's existing Outright Monetary Transactions scheme. They say that pledge to buy bonds, made in 2012 at the peak of the euro debt crisis but never used, exceeded the ECB's mandate and violated a ban on it funding governments.
Even though a final decision is not seen as imminent, the hearings will give some insight into the likelihood of the ECB being able to deliver on a full-blown QE programme.
GREEK RISKS
Greek 10-year bond yields rose above 7 percent for the first time since March on Tuesday, extending a rise prompted by political uncertainty and nervousness over plans by Athens to exit the country's bailout early. Yields were 32 bps higher on the day at 7.10 percent..
"We don't have buyers in the Greek bond market because of the political risk, the possibility of snap elections in early 2015," a bond trader at a major Greek Bank told Reuters.
Prime Minister Antonis Samaras won a parliamentary vote of confidence in his right-left coalition government last Friday but political analysts say a snap election is likely which could propel the radical leftist Syriza party to power.
A poll on Tuesday showed Syriza ahead of the government party.
Elsewhere, investors appeared to shrug off a decision by Spain's Catalonia region to cancel an independence referendum.
As widely expected in the market, Catalan leader Artur Mas called off the vote scheduled for November 9 and said there would be a consultation on breaking away from Spain instead.
"I was in Spain recently and clearly all our Spanish clients did not expect Catalonia to go ahead with the referendum," said Ciaran O'Hagan, a bond strategist at Societe Generale.
"That is why you have seen no market reaction." (Additional reporting by Lefteris Papadimos in Athens; Editing by Catherine Evans)
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