Euro zone government bond yields drop after weak economic data, ECB in focus

By Stefano Rebaudo

Jan 30 (Reuters) - Euro zone yields fell on Thursday amid weak economic data as investors awaited a European Central Bank policy meeting, which is widely expected to cut rates by 25 basis points and keep the door open to further policy easing.

The German economy contracted more than expected in the final quarter of last year, spurring recession fears.

ECB President Christine Lagarde is likely to argue that the direction of policy remained clear and that the risk of a trade war with the United States could sap weak growth even more.

Germany's 10-year bond yield DE10YT=RR, the euro area’s benchmark, fell 4.5 basis points (bps) to 2.53%.

U.S. 10-year Treasury yields US10YT=RR dropped 5 bps to 4.51% in early London trade. They reversed an earlier rise on Wednesday after Federal Reserve Chair Jerome Powell said he expects to see further progress on inflation.

Money markets priced in a 95% chance of a 25 bps ECB rate cut on Thursday IRPR and a deposit facility rate at 2.1% EURESTECBM8X9=ICAP at the end of 2025 from the current 3%.

Germany's two-year bond yield DE2YT=RR, more sensitive to ECB rate expectations, was down 4.5 bps at 2.23%.

Italy's 10-year yield IT10YT=RR was 4 bps lower at 3.62%.

The gap between Italian and German yields DE10IT10=RR -- a market gauge of the risk premium investors demand to hold Italian debt -- widened to 108 bps, but was not far from its lowest level since October 2021 at 104.50 bps.

The Italian economy stagnated in the fourth quarter, casting a shadow over prospects for this year.

Analysts said declining ECB policy rates would support demand for BTPs from investors keen on locking in high returns.

Michael Leister, strategist at Commerzbank, argued that this "ECB-euphoria" has faded, but lowering volatility should boost appetite for carry, supporting spreads.

A carry trade is an investment strategy where investors borrow money in a low-rate market and invest in a higher-yielding currency or asset.

The yield spread between OATs and Bunds DE10FR10=RR stood at 74 bps as a small panel of French senators and members of parliament will meet on Thursday to thrash out the final text of a much delayed 2025 budget, after talks teetered on the brink of collapse on Wednesday.

The spread widened to around 90 bps, its highest since 2012, in mid-January and end-November amid concerns that France would struggle to cut its growing budget deficit.

A reconciliation among political parties might still happen, "but it does reduce this government’s stability," Citi said in a research note.

"Overall, however, we don’t see this as a meaningful development given snap elections remain likely in third quarter and the 2025 budget is perhaps the only meaningful legislation ahead of that."

France's economic activity retreated slightly in the fourth quarter despite firm consumer spending as the boost from the Paris 2024 Olympic Games waned.