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By Emelia Sithole-Matarise
LONDON (Reuters) - German 10-year yields were on track for their biggest one-day fall in a year on Thursday as euro zone bonds rallied across the board after the U.S. Federal Reserve kept its monetary stimulus unchanged, at least for now.
Citing strains in the economy from tight fiscal policy, the Fed decided against trimming its $85 billion a month bond purchases, wrong-footing investors who had expected the central bank to cut the program at its policy meeting on Wednesday.
Euro zone bond yields fell across the credit spectrum after U.S. Treasury yields dropped in the wake of the Fed decision.
Global equities rallied as the prospect of prolonged monetary stimulus spurred investor appetite for riskier assets.
Bond yields and euro money market rates had been pushed higher in recent weeks by Treasuries on the prospect of reduced Fed purchases of U.S. debt.
"The punch bowl is again being refilled by the Fed and so everybody is very happy. That's why we saw equities rallying and bond yields falling," said KBC strategist Piet Lammens.
The Bund future was last up 121 ticks at 138.93 while cash German 10-year yields were down 11 basis points at 1.85 percent, having plumbed 1.81 percent earlier, the lowest since mid-August 2013. The yields looked set to clock their biggest one-day fall since September 2012.
The failure of the market to correctly read the Fed's intentions, however, may make the market more volatile as investors try to gauge Fed moves in the future, some market participants said.
"Overall, we still think tapering will still come. Going into the fourth quarter we think (U.S.) data will stabilize again triggering tapering concerns," Commerzbank strategist Michael Leister said.
"We therefore recommend using these episodes of strength in Treasuries and Bunds to reduce duration."
In line with other risky assets, prices for lower-rated Italian bonds rose, pushing 10-year yields down 7 bps to 4.32 percent.
Spanish equivalents were 5 bps lower at 4.35 percent, reversing some of their earlier falls as the market absorbed 3.1 billion euros of 3- and 15-year bonds Madrid auctioned earlier, drawing strong demand at lower borrowing costs.
Italian yields extended this week's fall and outperformance of Spanish equivalents on easing political tensions as former premier Silvio Berlusconi stepped back from threats to topple the government if lawmakers expel him from parliament after a tax fraud conviction.
Berlusconi, in a video message late on Wednesday shortly before a Senate committee took a first step towards expelling him, vowed to stay at the center of Italian politics but refrained from repeating threats to topple the government.
Leister at Commerzbank, however, said Italian yields could trade back above Spain's in coming days on lingering political uncertainty shadowing Rome's left-right coalition and concern about its ability to meet fiscal targets. Italian 10-year yields fell below Spanish for the first time in 18 months last week before reversing as political tensions eased.
"Even if Berlusconi is expelled from the Senate and the government stays together the coalition will remain fragile which renders BTPs pone to political risk," Leister said.
"Fundamentally, Italy is making less progress than Spain and against this backdrop we prefer Spain to Italy and we think these are better entry points to overweight Spain versus Italy."
Portuguese yields fell a modest 4 bps to 7.18 percent, with further moves constrained after Standard & Poor's warned it could downgrade the country's credit rating. It cited constitutional court challenges to spending cuts and doubts about Lisbon's return to markets.
"We would continue to avoid Portuguese government bonds, despite the high yields and a friendly Fed," Societe Generale strategists said in a note.
(Editing by Nigel Stephenson and Chris Pizzey, London MPG Desk, +44 (0)207 542-4441)