UPDATE-Short-end euro zone bond yields drop on ECB currency concerns

By Samuel Indyk

Jan 28 (Reuters) - Short-end euro zone bond yields fell on Wednesday after European Central Bank policymakers flagged that recent euro appreciation could start to have an effect on inflation and the path of interest rates.

The euro zone is a net energy importer, so even slight currency appreciation can significantly lower the price of energy and other imported goods, which could push inflation down.

Austrian central bank governor Martin Kocher said in an interview with the Financial Times that the gains so far in the euro were "modest" and did not yet require a response, but if sharper appreciation lowered inflation projections then they might need to think about cutting rates.

Fellow policymaker Francois Villeroy de Galhau, of France, said the central bank was closely monitoring the currency and possible consequences for lower inflation.

RATE CUT BETS

Markets slightly added to bets on a rate cut by the summer following the comments. Futures imply about a 22% chance of a rate cut by July, from around 15% on Tuesday EURESTECBM5X6=ICAP.

Germany's 2-year bond yield DE2YT=RR, which is sensitive to changes in ECB rate expectations, fell 2.5 basis points to 2.078%, its lowest level in a week.

Rene Albrecht, analyst at DZ Bank, already expects euro zone inflation to drop below 2% in the first and second quarters of this year due to base effects from higher energy prices dropping out of the annual calculation.

"If you add another layer of deflationary impulses from the exchange rate, we can make a case that the ECB might cut once or twice," Albrecht said, although he noted that the euro would need to strengthen further for that to be the case.

The euro EUR=EBS has strengthened sharply against the dollar in recent days, rising above $1.20 on Tuesday after U.S. President Donald Trump said the value of the dollar was "great". It was last at $1.1977 against the dollar.

The dollar index =USD, which measures the currency against six peers including the euro, fell to its lowest since early 2022.

SPREAD BETWEEN GERMAN AND FRENCH BENCHMARKS TIGHTENS

Germany's 10-year yield DE10YT=RR, the benchmark for the euro zone, was down 2 bps at 2.852%.

France's 10-year yield FR10YT=RR dropped 2 bps, with the spread between German and French 10-year yields DE10FR10=RR touching 55.15 bps, its tightest level since French President Emmanuel Macron called a snap election in June 2024.

The spread has been tightening aggressively in the last two weeks after the French government said it would use constitutional powers to pass a budget for 2026.

"The story has run its course now and it won't tighten that much anymore," DZ Bank's Albrecht said.

"Our view is that the spread should stick to a range between 55 and 65 basis points for the foreseeable future, since they don't get their deficit down and it's almost certain they won't in 2027."

Investors were looking ahead to the Federal Reserve rate decision later on Wednesday. Analysts and economists widely expect the central bank to keep the Fed funds rate unchanged, after a cut in December to a range of 3.5%-3.75%.

Markets are fully pricing in the next rate cut in July, with almost two quarter-point moves priced in by the end of the year.