Euro zone bond yields drop as investors focus on defence spending, tariffs, ECB

By Lucy Raitano

LONDON, March 4 (Reuters) - Euro zone bond yields mostly fell on Tuesday as traders weighed the prospect of higher European borrowing to fund defence spending with new U.S. tariffs on Mexico and Canada and a doubling of duties on Chinese goods.

The European Central Bank meets on Thursday and is expected to deliver a 25-bp rate cut, an expectation bolstered by euro zone inflation figures on Monday.

Germany's 10-year bond yield DE10YT=RR, the euro zone's benchmark, fell as much as 6 basis points (bps), but was last down 1 basis point to 2.485%.

The drop in yields was more evident in shorter-dated bonds, which are more sensitive to interest rate policy. Germany's 2-year bond yield DE10YT=RR fell 5.5 bps to 2.013%, having earlier hit its lowest since December 12 at 1.986%.

Morgan Stanley analysts on Tuesday changed their call for ECB rate expectations, now seeing the central bank cutting rates again in April, spurred by weak inflation and growth data.

Longer-dated yields rose 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.

"Europe will try to come up with inventive ways of funding this," said Nathan Sweeney, CIO of multi-asset solutions at Marlborough, citing the option of using seized Russian assets.

"If they go down that route it has less implications for the bond market."

Germany's central bank on Tuesday proposed a reform of the country's constitutionally enshrined cap on borrowing, which could give the government up to 220 billion euros ($231.46 billion) worth of extra cash for defence and investment this decade.

"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," said Kenneth Broux, head of corporate research, FX and rates at Societe Generale

"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 up 3.5 bps on Tuesday at 2.835%.

U.S. Treasury yields dropped 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.

"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.

($1 = 0.9505 euros)