Weak growth, ECB boost traders' euro area rate cut confidence

Corrects interest rate probability in paragraph 5

By Yoruk Bahceli and Samuel Indyk

LONDON, Jan 30 (Reuters) - Traders grew more confident on Thursday that the European Central Bank would deliver three more rate cuts this year, as weak growth data followed by the bank's latest rate reduction highlighted the need for more easing.

The ECB cut rates by 25 basis points (bps) to 2.75%, as expected, and kept the door open to further policy easing, helping push two-year German bond yields to three-week lows around 2.18% DE2YT=RR.

The decision came hot on the heels of data showing the euro zone economy unexpectedly stagnated last quarter, falling short of expectations for a 0.1% expansion, as two straight years of contraction in Germany weighed on the bloc as a whole.

That added to the gloom as U.S. President Donald Trump's tariff threats cast a shadow over an already sluggish euro zone economy, though he has so far not imposed blanket tariffs as feared.

Traders became more confident that the ECB would deliver three more rate cuts this year, now expecting around 70 bps of cuts by year-end, meaning more than an 80% chance of three cuts.

Last Friday, markets priced around a 60% chance of three moves.

"The ECB meeting was a tad dovish, with the mention of headwinds to growth, or at least it was not hawkish," said Barclays’ head of euro rates strategy Rohan Khanna, adding that Thursday's growth data was also below the ECB's expectations.

Euro zone bond yields were broadly lower. Germany's two-year yield DE2YT=RR, sensitive to rate expectations, was set for its biggest daily fall since late November, down around 8 bps in late trade.

Ten-year Bund yields DE10YT=RR fell 6 bps to 2.52%, while Italy's 10-year yields IT10YT=RR dropped to 3.58%, the lowest in a week.

The euro EUR=EBS, which usually takes a hit from rising rate-cut bets, was 0.1% higher on the day as the dollar weakened on the back of weaker-than-expected U.S. growth data.

Europe's STOXX 600 .STOXX equity index was up 0.8%, relatively unmoved by the growth data or the ECB. An index of euro zone bank stocks .SX7E held near the highest since 2011 it rose to earlier.

BLEAK OUTLOOK

With the bloc facing a bleak outlook, some analysts said the ECB would have to cut rates below the 2% that markets expect to see by year-end. A 2% deposit rate falls in line with estimates for the so-called neutral rate in the euro zone, which neither restricts nor boosts growth.

"We expect to see developments on the tariff front in coming weeks. This will be a critical driver of ECB policy going forward," said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, who expects the ECB to cut rates to 1.5% by year-end, as concerns around global trade tensions weigh.

"But what happens after that... we still have to see," he said.

A further ECB cut is likely to go through in March without much resistance among policymakers before the debate between them on further easing becomes more heated, possibly implying an April pause, three of them told Reuters on Thursday.

Traders see an April move as a coin toss, assuming the ECB cuts rates in March.

The bank's Thursday move also reinforced policy divergence between the euro zone and the United States, where the Federal Reserve held rates steady on Wednesday and said there was no rush to cut them again.

The closely-watched premium 10-year U.S. Treasury yields pay over German peers DE10US10=RR, which signals the difference in economic outlook between the two regions, rose back above 200 bps.

It dropped below that level for the first time since November earlier this week as German bond yields have risen in January while Treasury yields fell.