Euro zone yields drop before German vote on spending plans, Fed

By Stefano Rebaudo

March 17 (Reuters) - Euro zone government bond yields dropped on Monday, one day ahead of a German parliament vote on the country's spending plans and at the start of a week packed with central bank policy meetings.

Plans by Chancellor-in-waiting Friedrich Merz to unleash a massive state borrowing programme were hit by last-minute legal challenges from the far-right Alternative for Germany at the country's constitutional court.

Meanwhile, the Ifo Institute cut its forecast for the euro zone’s biggest economy to 0.2% on Monday, citing subdued consumer sentiment and companies' reluctance to invest.

The spending plan will be a "positive" for Germany's prized triple-A sovereign credit rating, S&P Global said earlier this month.

Germany's 10-year government bond yields DE10YT=RR were down 7 basis points (bps) at 2.8%. They hit 2.938% last week, the highest since October 2023, as expectations for more bond supply drove yields higher.

The Federal Reserve and Bank of Japan will announce rate decisions on Wednesday, followed on Thursday by the Bank of England, Sweden's Riksbank and the Swiss National Bank.

BofA argued that the Fed will most likely hold rates, emphasising "patience over panic."

"U.S. rates may react to Fed communications with a curve flattening, reflecting the challenges of navigating sticky inflation and on-hold policy stance," said BofA rate strategist Mark Cabana.

"We would encourage clients to fade any curve flattening with the expectation that further declines in risk assets could push the market to price more Fed cuts."

There are "no guarantees" there will not be a recession in the United States, although there could be an adjustment, Treasury Secretary Scott Bessent said in an interview on Sunday.

Germany's 2-year bond yield DE2YT=RR, more sensitive to European Central Bank policy rates, was little changed at 2.186%. It hit 2.319% two weeks ago, the highest since mid-January.

U.S. tariffs and Ukraine remained in focus after U.S. President Donald Trump said he would not create exemptions on steel and aluminium tariffs, and also that he planned to speak to Russian President Vladimir Putin on Tuesday and discuss ending the war.

Tariffs are expected to boost inflation and depress growth, while a peace deal in Ukraine should be good for risky assets and the euro area economy.

Italy’s 10-year bond yields IT10YT=RR dropped 9 bps to 3.853%. The yield gap between Italian and German bonds DE10IT10=RR - a market gauge of the risk premium investors demand to hold Italian debt - was at 104 bps.

The spread between French and German bonds DE10FR10=RR stood at 67 bps, the tighter end of its recent range, after Fitch left France's rating unchanged.

Separately, U.S. economic data on Monday painted a mixed picture with retail sales rising a smaller than expected 0.2% in February.

The spread between U.S. and German 10-year bond yields DE10US10=RR widened to 146 basis points after touching its narrowest since July 2023 at 130.9 basis points last Wednesday.