Euro zone yields drop as investors raise bets on ECB rate cuts after data

Updates at 1500 GMT

By Stefano Rebaudo

Sept 27 (Reuters) - Euro zone government bond yields dropped on Friday after inflation data from France and Spain led investors to increase their bets on future European Central Bank interest rate cuts.

Softer than expected U.S. inflation data added to the mood, pushing European yields down a little further.

French consumer prices rose less than anticipated in September, aided by a decline in energy costs. Spain's European Union-harmonised 12-month inflation eased to 1.7%, lower than the 1.9% expected by analysts polled by Reuters.

The German and euro area figures are due next week.

Germany's 10-year bond yield DE10YT=RR, the benchmark for the euro zone bloc, fell 3 basis points to 2.14%, and Germany's two-year bond yield DE2YT=RR was last down 2 bps at 2.09%. It hit 2.065%, its lowest level since December 2022, earlier in the session.

The declines came as money markets priced in an 80% chance of an ECB rate cut in October EURESTECBM1X2=ICAP from around 20% early this week and 60% before data.

They are inclined to discount a bigger move in December as forwards on the ECB euro short-term rate (ESTR) EURESTECBM2X3=ICAP fully discounted a 50 bps cut by year-end.

Major banks including Goldman Sachs and JPMorgan on Friday also revised their ECB rate path forecasts to include a cut in October.

"This week's data have sufficiently moved the needle," Greg Fuzesi, euro area economist at JPMorgan, said in a note explaining their call change.

Fuzesi said this week's PMI data "disappointed significantly" and "the early hints from today's French and Spanish CPI reports is also that core inflation may be edging lower."

Purchasing Managers Index survey data released Monday showed euro zone business activity contracted sharply and unexpectedly this month.

Also in the mix for markets, Friday data showed U.S. inflation pressures continued to abate.

The personal consumption expenditures price index rose 0.1% month-on-month in August, in line with expectations, and 2.2% year-on-year, the smallest such gain since February 2021 and down from 2.5% in July.

The U.S. central bank tracks the PCE price measures for its 2% inflation target.

U.S. yields and European yields moved slightly lower immediately after the data. US/

The gap between French and German 10-year yields DE10FR10=RR - a gauge of risk premium that investors demand to hold France’s government bonds - was last at 79 bps, up from around 70 bps two weeks ago.

It reached its widest since 2012 during France's parliamentary election earlier this year, at beyond 85 bps.

French Budget Minister Laurent Saint-Martin said the deficit was at risk of topping 6% of economic output, far above the 5.1% that the previous government had estimated in the spring.

He added that the government would focus a budget squeeze on spending cuts first and then tax increases, amid calls for a realistic plan to rein in a fiscal shortfall which threatens France's credibility with financial markets.

Italy's 10-year yield IT10YT=RR fell 2 bps to 3.46% and the gap between Italian and German yields DE10IT10=RR was 131 bps.

(Reporting by Stefano Rebaudo; additional reporting by Alun John; Editing by Elaine Hardcastle, Gareth Jones, Alex Richardson and Jonathan Oatis)

((stefano.rebaudo@tr.com))