Euro zone bond yields lag US Treasuries after US economic data

By Stefano Rebaudo

Sept 5 (Reuters) - Euro zone government bond yields lagged behind U.S. Treasuries, which dropped sharply after data releases on Friday, sending the spread between German and U.S. borrowing costs to its lowest level since early April.

U.S. job growth weakened in August while the unemployment rate increased, confirming that labour market conditions were softening and boosting bets on Federal Reserve rate cuts.

Stronger economic prospects and expectations of "higher for longer" policy rates slowed the decline in euro area yields.

Money markets priced in 70 basis points of Fed monetary easing by December, implying two 25-bps cuts and an 80% chance of a third move, from 60 bps before economic figures.

They also indicated a 25-bps rate cut in September, along with a 10% chance of a 50-bps move — up from zero before the data release.

"While we expect a hot (U.S.) CPI reading next week, we do not think it will sway the vote (in favour of a rate cut in September) after this labour market report," said Rogier Quaedvlieg, senior U.S. economist at Abn Amro.

"Further moves will be highly dependent on incoming data," he added, arguing he sees significant pickup in inflation.

Germany’s 10-year bond yield DE10YT=RR, the benchmark for the euro zone bloc, fell 5.5 bps to 2.66%. It hit 2.80% on Tuesday, its highest level since March 26.

The benchmark 10-year U.S. Treasury yield US10YT=RR dropped 10 bps to 4.08%, narrowing the yield gap between U.S. and German borrowing costs to 141.5 bps, its lowest since April 7, when a short-lived but sharp selloff in U.S. assets started.

"Market pricing for the Fed funds rate to fall all the way to 3% next year still seems optimistic," said David Rees, head of global economics at Schroders.

"Twin monetary and fiscal stimulus are more likely to fuel a pick-up in inflation than real gross domestic product (GDP) growth next year."

Ultra-long euro zone borrowing costs dropped late this week ahead of U.S. data, after hitting multi-year highs.

Expectations of rising debt levels have strengthened the case for a higher risk premium on longer-dated bonds, amid plans for a sharp increase in German fiscal spending.

Yields on 30-year German bonds DE30YT=RR fell four bps to 3.30%. They reached 4.434% on Wednesday, their highest level since summer 2011.

Germany’s 2-year yields DE2YT=RR, more sensitive to expectations for European Central Bank policy rates, fell three bps to 1.93%.

France’s 30-year government bond yield FR30YT=RR was down 3 bps to 4.37%. It reached 4.523% on Tuesday, its highest since June 2009.

The yield gap between safe-haven German Bunds and 10-year French government bonds DE10FR10=RR - a market gauge of the risk premium investors demand to hold French debt - widened to 77 bps after reaching 82 bps last week.

"Rather than the scale of the deficit reduction, which this year is aligned with the government’s pledges, the real problem for France lies in political instability and the difficulty to vote budgets," said Benjamin Melman, global chief investment officer at Edmond de Rothschild Asset Management.

"We have not reviewed our allocation to Europe in response to French events. In bond markets, we prefer carry strategies and avoid maturities that are too long."

France’s far-right National Rally said on Monday it was preparing for snap elections, anticipating that opposition parties will bring down the minority government in a confidence vote scheduled for September 8.