UPDATE 4-Euro zone bond yields fall as German inflation cools off

·3 min read

(Updates with late trade price action)

By Stefano Rebaudo

June 29 (Reuters) - Euro zone government bond yields dropped sharply on Wednesday following lower-than-expected German inflation data ahead of a bloc-wide Friday read-out the ECB will watch closely.

German consumer inflation dipped in June, the first month that the effects of government measures to dampen high fuel prices were included.

The data comes ahead of Friday's first estimate of June inflation for the euro zone as a whole, which the ECB should scrutinize ahead of its July 21 policy meeting where it has said it will hike rates for the first time since 2011 to tackle record high inflation in the euro zone.

Rohan Khanna, a research strategist at UBS, commenting on earlier German state-level data, said it "might be a turning point that could moderate the approach of the European Central Bank".

However, it is probably "too early to extrapolate ahead of Friday's euro zone (inflation) numbers", he added.

Economists have also warned against seeing the German data, driven by one-off effects, as an end to price pressures.

Nonetheless, Germany's 10-year government bond yield, the benchmark for the euro zone bloc, was down nearly 13 basis points (bps) to 1.52% by 1523 GMT, extending its fall after the U.S. session open.

Thursday's moves follow a 20 bps rise in German yields across Monday-Tuesday in another sign of the volatile trading and low liquidity gripping financial markets.

Yields fell even as data from Spain showed that inflation rose to 10.2% in June, the first time it surpassed 10% since April 1985, from 8.7% the previous month and far higher than a Reuters poll expected.

"Barring (Germany's) government induced price reductions, eurozone inflation seems to have increased in June," Aline Schuiling, senior economist at ABN AMRO, said in a note to clients.

Money market bets on ECB hikes were little changed, with 155 bps of hikes to the bank's -0.50% policy rate priced in by December, from 163 bps on Tuesday, and a terminal rate of around 1.9% priced in by July 2023, from around 2%.

"The ECB is under pressure to deliver (rate hikes), and inflation will keep pressure on them," said Chris Attfield, European rates strategist at HSBC.

"The euro area economy is running less hot than in the U.S, and the window to hike is closing; but the narrative will probably change by the end of the year if inflation subsides and economic growth slows down."

Central bank speakers at the ECB Forum in Sintra, Portugal, remained under the spotlight as analysts watched for any hint about the ECB potentially moderating its hawkish tone.

Italy's 10-year government bond yield was last down 17 bps to 3.49%, with the spread between Italian and German 10-year yields tightening to 198 bps.

Analysts expect the spread to remain around 200 bps before the ECB's July policy meeting. Markets want to see how credible its upcoming anti-fragmentation tool - to contain an excessive divergence in member states' borrowing costs - is before taking any price action, they say.

(Reporting by Stefano Rebaudo, additional reporting by Yoruk Bahceli; Editing by Alison Williams, Peter Graff and Alex Richardson) ;))