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

Updates in late European trading

By Stefano Rebaudo and Harry Robertson

Jan 28 (Reuters) - Euro zone government bond yields rose on Tuesday, reversing 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.

Meanwhile, the risk premium investors demand to hold French and Italian debt over German debt fell to multi-week lows in a sign of solid investor demand for riskier debt.

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

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

Germany's 10-year bond yield DE10YT=RR rose 3 basis points (bps) to 2.56%, after dropping 4 bps the day before.

Money markets priced in around a 90% chance of a 25 bps ECB rate cut on Thursday IRPR and a deposit facility rate at roughly 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.

Meanwhile, on Tuesday the closely watched spread between France and Germany's 10-year bond yields DE10FR10=RR narrowed 5 bps to its tightest since Nov. 21 at 71.7 bps.

"In general, we see a strong demand for EGBs (European government bonds) since the start of the year and, despite volatility, EGB spreads have traded well," said Emmanouil Karimalis, macro rates strategist at UBS.

"This has also helped OATs (French bonds) – despite remaining fiscal uncertainty."

France's first syndicated government bond sale since a snap election last year unleashed turmoil in its markets saw record demand, Reuters reported last week.

Germany's two-year bond yield DE2YT=RR, which is more sensitive to ECB rate expectations, was up 2 bps at 2.268%.

Italy's 10-year yield IT10YT=RR was flat at 3.635%.

The gap between Italian and German yields DE10IT10=RR was at 107 bps after hitting a one-and-a-half-month low at 105.90 earlier in the session.

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.