Spanish CPI shock flags euro deflation risks

LONDON (Reuters) - The euro and benchmark German bond yields slid to three-week lows on Friday as a surprise fall in Spanish inflation bolstered investors' bets the European Central Bank will ease policy next week to ward off the threat of deflation.

Equity markets drew support from the renewed potential for looser ECB monetary policy, as well as reports Beijing could fast-track infrastructure spending to boost the Chinese economy.

The 0.2 percent annual decline in Spanish consumer prices this month was larger than expected, the weakest figure since October 2009, and enough to push Spanish 10-year government bond yields to a new eight-year low.

Preliminary German inflation data for March later on Friday will now come under even greater scrutiny for signs that the threat of deflation is spreading from peripheral euro zone economies like Spain to the bloc's powerful core.

"The market is reacting strongly, and this really indicates that the market is nervous," said Michael Leister, rates strategist at Commerzbank in London.

"The bar is very high for further ECB easing, and we think the ECB is still going to stay on hold. But this is going to underpin these easing expectations," he said.

The euro hit a three-week low of $1.3704, falling further back from the $1.40 level many analysts think would be too strong for the fragile euro zone economy in the eyes of ECB policymakers.

Germany's 10-year Bund yield fell to 1.52 percent