Euro zone bond yields fall as tariffs take effect, EU focuses on spending

By Lucy Raitano

LONDON, March 4 (Reuters) - Euro zone bond yields fell on Tuesday as traders focussed on new U.S. tariffs on Mexico and Canada, a doubling of duties on Chinese goods, and news that President Donald Trump had paused military aid to Ukraine.

Germany's 10-year bond yield DE10YT=RR, the euro zone's benchmark, fell as much as 6 basis points and was last down 2 basis points (bps) to 2.469%.

The drops were more evident in shorter-dated bonds with Germany's 2-year bond yield DE10YT=RR down 5 basis points (bps) to 2.025%.

Italy's 10-year yield IT10YT=RR was 2 bps lower at 3.528% while the 2-year yield IT2YT=RR was down 5 bps to 2.321%.

Longer-dated yields had risen sharply on Monday, as traders reacted to the prospect of an increase in government spending on defence, as European leaders rallied around Ukraine.

On Tuesday, the European Commission floated the possibility of new joint European Union borrowing to fund an expansion of defence capabilities - something that will come under discussion at Thursday's special summit.

"The news flow that we’re getting from the U.S. regards to Ukraine ... is the most important driver for me. There’s not been any confirmation of tariffs on the EU in the same sense as on Canada and Mexico and China. And of course we have the ECB on Thursday," Kenneth Broux, head of corporate research, FX and rates at Societe Generale, said.

Trump paused military aid to Ukraine following his clash with Ukrainian President Volodymyr Zelenskiy last week and pressure is growing on European nations to spend more on their own security, as well as Ukraine's.

"There’s a lot of uncertainty and we’re trying to square off German defence spending plans, which we suppose should result in higher bond yields and higher borrowing, Broux added.

"On the flipside we have the situation on the ground in Ukraine where there doesn't seem to be any guarantee that the U.S. will backstop any peacekeeping efforts by European allies," he added.

Yields on 30-year German bonds DE30YT=RR, which on Monday rose nearly 12 bps, were last up 2 bps at 2.819%.

U.S. Treasury yields edged down on Tuesday US10YT=RR, extending Monday's decline following the latest Institute for Supply Management manufacturing survey, which showed a sharp spike in inflation expectations in February, with suppliers citing tariffs numerous times.

"This morning Bunds are in catch-up mode with the bid in USTs experienced post close on Monday but with the added spin that they are bull flattening," RaboBank rates strategists said in a note, referring to the larger fall in shorter-dated yields than longer-dated ones.

Broux said the latest ISM survey shows tariffs are already hurting the U.S. economy.

"If the U.S. economy hits a soft patch in Q1, Europe will not be unscathed, there will be a downward effect," he said.

Meanwhile, the European Central Bank meets on Thursday and is expected to deliver a 25-bp rate cut, an expectation bolstered by latest euro zone figures on Monday that showed inflation dipped a bit less than expected last month, which also solidified bets for further policy easing ahead.