Euro zone yields reverse Monday's decline, central banks in focus

By Stefano Rebaudo

Jan 28 (Reuters) - Euro zone government bond yields rose on Tuesday, reversing the Monday's decline, with investors looking to the European Central Bank and the U.S. Federal Reserve policy meetings later this week for more clues about the outlook for interest rates.

Borrowing costs on both sides of the Atlantic fell on Monday, as investors sought refuge in safe-haven assets amid growing concerns over the lofty valuations in the U.S. tech stocks. Bond prices move inversely with yields.

U.S. stock futures and European shares steadied on Tuesday, after Nasdaq suffered its biggest one-day percentage drop since Dec. 18 as a low-cost Chinese artificial intelligence model prompted a steep selloff in U.S. chipmakers.

Germany's 10-year bond yield DE10YT=RR rose 5 basis points (bps) after dropping 4 bps the day before.

Money markets priced in a 90% chance of a 25 bps ECB rate cut on Thursday IRPR and a deposit facility rate at 2.1% EURESTECBM8X9=ICAP at the end of 2025, down from the current 3%.

Some market participants argue that the ECB would easily cut by 50 bps in the next two meetings as inflation concerns fade.

"Further rate reductions are therefore likely, even as the hawkish members will increasingly raise the question of when exactly the ECB should stop its cutting cycle at upcoming meetings," said Felix Schmidt, economist at Berenberg.

Some ECB hawks see the neutral rate above 2.5%, casting some doubt over how far the easing can go.

ECB executive board member Isabel Schnabel said in mid-December 2024 that a recent analysis by the bank's staff suggested a neutral rate between 1.5 and 3% in nominal terms, adding the policy rates were approaching neutral territory.

A day before the ECB meets, the U.S. Fed's Federal Open Market Committee will announce its decision on rates.

While Fed policymakers are expected to keep rates on hold on Wednesday, the larger story unfolding will be how they respond to moves by President Donald Trump that are likely to shape the economy this year, including demands the Fed continue lowering borrowing costs.

Germany's two-year bond yield DE2YT=RR, which is more sensitive to ECB rate expectations, was down 3 bps at 2.26%.

Italy's 10-year yield IT10YT=RR was 2 bps lower at 3.64%.

The gap between Italian and German yields DE10IT10=RR - a gauge of the risk premium investors demand to hold Italian debt - was at 110 bps after hitting a one-and-a-half-month low at 105.90 earlier in the session.