German two-year yields set for best month since April as strong euro muddies ECB path

By Stefano Rebaudo

Jan 30 (Reuters) - German two-year government bond yields were set for their largest monthly drop since last April on Friday, driven lower by investors betting the European Central Bank will factor in the deflationary drag from a stronger euro as it considers monetary policy.

The euro hit a 4-1/2-year-high against the dollar on Tuesday after President Donald Trump said the U.S. currency's value was "great", when asked whether he thought it had declined too much.

German 2-year yields DE2YT=RR, which are more sensitive to expectations for policy rates, were up 0.5 basis points at 2.06% and on track for a 6.5-bp weekly decline, the biggest since October. In January, they have fallen by 6 bps, the largest monthly fall since April last year.

Money markets priced in around a 30% chance of a rate cut in September EURESTECBM6X7=ICAP, up from less than 10% a week ago, while indicating a 20% probability of a rate hike in April 2027, down from 50% EURESTECBM11X12=ICAP.

ECB POLICY MEETING IN FOCUS

Investors are awaiting next week's ECB monetary policy meeting.

“Policy rates might be unchanged again in February, but the ECB has no shortage of issues to ponder,” said Mark Wall, chief European economist at Deutsche Bank Research.

“Is a ‘Second China Shock’ a more significant concern to Europe than U.S. tariffs? And is currency stability becoming a challenge to the smooth transmission of monetary policy?”

Investors have been worried that the strength of the euro could amplify the deflationary impact of China's export machine and become the catalyst that jolts the ECB out of its "good place" and into further interest rate cuts.

Economists also flagged that geopolitical risks remain a major theme this year, meaning the ECB has to stay nimble and able to respond quickly.

Long-dated U.S. Treasuries fell on Friday, with benchmark 10-year yields US10YT=RR up 3 bps at 4.26%, after Trump nominated former Federal Reserve Governor Kevin Warsh to head the U.S. central bank.

DATA CONFIRM EURO ZONE RESILIENCE

Germany’s 10-year government bond yield DE10YT=RR, the euro zone’s benchmark, rose 1.5 bps to 2.85%.

Borrowing costs were little changed after solid economic data on Friday showed that euro zone economies grew at a modest but steady pace, while inflation stood at 2% in Germany’s most populous state, North Rhine-Westphalia.

“We have seen some temporary good performances in Germany quickly reverse in the past few years, so the big question now is whether this will be repeated in the coming quarters,” said Franziska Palmas, senior Europe economist at Capital Economics.

The 30-year yield DE30YT=RR was up 1.6 bps at 3.5%. It rose to 3.556% in late December, its highest since summer 2011.

The yield gap between French government bonds and safe-haven Bunds DE10FR10=RR - a market gauge of the risk premium investors demand to hold French debt - widened to 58 bps after hitting a fresh 19-month low at 55.50 bps, on Monday.

Italy’s 10-year government bond yields IT10YT=RR rose 2 bps to 3.47%. The gap versus Bunds was around 61 bps, after tightening to 53.50 in mid-January, its lowest level since August 2008.