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

By Stefano Rebaudo

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

Borrowing costs inched higher early on Friday, after falling the day before, when the ECB's policy decision barely moved expectations for the outlook for interest rates.

Germany's rate-sensitive two-year bond yield DE2YT=RR, was down 81 basis points (bps) at 2.18% on Friday. It was set to end the week 16 bps lower in its biggest fall since the week of 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-bp cuts and a 20% chance of a fourth 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, while Italy stagnated and French growth retreated slightly.

Germany's 10-year government bond yield DE10YT=RR, the euro area's benchmark, fell 6 bps to 2.457%, 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 74 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 IT2YT=RR posted its biggest fall since mid-October, 8 bps lower to 2.44%.

The gap between Italian and German 10-year yields DE10IT10=RR was at 109.1 bps, not far from its lowest level since October 2021 at 104.50 bps.