Euro area 2-year yields set for biggest weekly fall in months

By Stefano Rebaudo

Jan 31 (Reuters) - Euro area short-dated government bond yields were on track to record the biggest weekly drop in months as a raft of weak economic data led traders to ramp up their bets on future European Central Bank rate cuts.

Borrowing costs inched higher early on Friday after falling the day before, as Thursday's European Central Bank policy meeting barely moved expectations for the monetary easing path.

Germany's two-year bond yield DE2YT=RR, more sensitive to ECB rate expectations, was down 8 basis points (bps) at 2.13% on Friday. It was set to end the week 16 bps lower in its biggest fall since the week ending on Sept. 23.

"The ECB will likely want to provide further support to the weak euro zone economy. German data from today – soft retail sales while the unemployment rate is edging up – also fit this view," said Salomon Fiedler, economist at Berenberg.

Money markets priced in an ECB deposit facility rate at 1.95% EURESTECBM8X9=ICAP at the end of 2025 - which implies three 25 bps cuts and a 20% chance of a fourth move by year-end -, from over 2.1% early this week.

Germany's core inflation eased markedly, while the unemployment rate rose as the weakness of Europe's biggest economy took its toll on the labour market.

French consumer prices increased slightly less than anticipated to 1.8% year on year.

"We expect overall inflation in France to remain close to the current level on average over 2025 before returning to close to 2% in 2026," said Charlotte de Montpellier, senior economist, France and Switzerland at ING.

Data showed on Thursday the economy contracted spurring recession fears in Germany, stagnated in Italy, and retreated slightly in France.

Germany's 10-year government bond yield DE10YT=RR, the euro area's benchmark, fell 4 bps to 2.46%, and was about to end the week 6 bps lower.

However, euro zone consumers and economists increased their inflation expectation for this year, surveys showed on Friday.

U.S. Treasury yields edged up with the 10-year US10YT=RR rising one bp to 4.52%, as data showed U.S. prices increased in December while consumer spending surged.

The yield spread between OATs and Bunds DE10FR10=RR - a market gauge of the risk premium investors demand to hold Italian debt - tightened to 73 bps, after French Finance Minister Eric Lombard said on Friday that talks on getting the 2025 budget passed through parliament were "on the right track".

It widened to around 90 bps, its highest since 2012, in mid-January and end-November amid fears that France would be unable to cut its growing budget deficit.

Italy's 2-year government bond yield IT10YT=RR was 7 bps lower to 2.44% and about to end the week 19 bps lower, in biggest fall since mid-October.

The gap between Italian and German 10-year yields DE10IT10=RR was at 108.50 bps, not far from its lowest level since October 2021 at 104.50 bps.