Euro zone bond yields dip from three-week high, defence spending in focus

Updates prices before European close

By Greta Rosen Fondahn

Feb 20 (Reuters) - Longer-dated euro zone bond yields dipped from around their highest in three weeks on Thursday, while geopolitics remained in focus and markets awaited more clarity around the prospects of increased defence spending in Europe.

U.S. President Donald Trump denounced Ukrainian President Volodymyr Zelenskiy as a "dictator" on Wednesday and warned he had to move quickly to secure peace or risk losing his country.

Germany's 10-year bond yield DE10YT=RR, the benchmark for the euro zone bloc, was last down 1 basis point (bp) at 2.536%, after earlier hitting its highest since January 30 at 2.563%. Yields move inversely to prices.

Euro zone bonds have sold off this week on expectations that European governments would ramp up issuance to fund bigger defence spending.

While bond moves were muted on Thursday, 10-year German Bund yields were on track for their biggest weekly jump since early January, having risen about 11 bps on the week.

"The politicians seem to realise that Europe needs to prepare for a situation where it cannot rely on the U.S. when it comes to how much responsibility they will take for defending Europe in the coming years," said Jussi Hiljanen, head of European rates strategy at SEB.

"It's a new playing field altogether. It's going to be reflected in the funding needs."

Hiljanen said however that there might be room for a downwards correction of the past days' rise in longer-dated euro zone yields, saying the moves were "maybe a bit exaggerated".

Italy's 10-year yield IT10YT=RR was down 2 bps at 3.618%, after touching its highest since January 29 on Wednesday at 3.644%.

The gap between Italian and German yields DE10IT10=RR stood at 108 bps.

Traders also assessed minutes from the U.S. Federal Reserve's January policy meeting, published on Wednesday, showing that Fed officials discussed slowing or pausing the ongoing drawdown of its balance sheet holdings. This sent U.S. Treasury yields down.

PARED ECB BETS

Germany's two-year bond yield DE2YT=RR, which is more sensitive to European Central Bank rate expectations, fell 3 bps to 2.148%.

It rose 4 bps on Wednesday after ECB board member Isabel Schnabel told the Financial Times that the central bank should start a discussion about whether further rate cuts are necessary.

"Coming from her, such remarks should not surprise as Schnabel has previously been estimating the neutral rate as high as 3%," said ING analysts in a note.

"But what has changed in the meantime is the perception of the fiscal backdrop, where aside from the immediate supply implications, the prospect for larger defence investments also argues for a more expansionary stance ahead," they added.

The ECB sees the neutral rate, which neither stimulates nor restricts growth, at between 1.75% and 2.25%. The bank's deposit rate is currently 2.75%.

Also in the mix, German producer prices rose less than expected in January, increasing by 0.5% on the year, the federal statistics office reported on Thursday. Analysts polled by Reuters had expected a 1.3% increase.