German bonds set for best start to the year since 1977

By Amanda Cooper

LONDON, Jan 6 (Reuters) - Euro zone government bond prices edged down on Friday ahead of U.S. employment data, as expectations for more benign inflation readings in the bloc kept German yields on course for their largest drop for the first week of the year in over 40 years.

German 10-year bond yields DE10YT=RR, which serve as a benchmark for the broader euro zone, edged up 1 basis point on the day to 2.31%. But they've fallen by almost 30 bps this week and were on Friday heading for their largest weekly decline since late October and, according to Refinitiv data, the biggest in the year's first week since 1977.

Lower consumer inflation readings in Germany, France and Spain have prompted investors to reassess how far interest rates are likely to rise.

"This is a very, very meaty decline in European rates. Ten-year Bund yields are down 30 basis points in the first three days," Rabobank senior rates strategist Richard Maguire said.

"This is the product of weaker-than-anticipated inflation data in the euro zone, the decline in energy prices on the back of the unseasonably warm weather and speculation that 'peak inflation' is behind us," he said.

That was giving rise to hopes that the European Central Bank rate path might be less aggressive than expected, he added.

Energy prices, which rocketed last year after Russia's invasion of Ukraine disrupted flows of gas to Europe, have eased, offering some much- respite to households and businesses and taking some pressure off the ECB.

A month ago, money markets were pricing in a terminal ECB rate of around 2.8% by September. But at the bank's December meeting, President Christine Lagarde signalled this was too low. Markets then priced a rate of 3.5%.

Now, that rate is expected to be around 3.37%. 0#ECBWATCH

Yields on the bonds of more heavily indebted such as Italy have fallen more sharply. Ten-year BTP yields IT10YT=RR have dropped by more than 35 bps this week. They were last up 4 bps on the day at 4.365%.

Yet inflation in the euro zone is at 10.1%, still well above the ECB's target rate of 2%. That makes pricing in the bond market look overly optimistic, according to Rabobank's Maguire said.

"Even with inflation past its peak, it's still a multiple of that target," he said.

The main risk event for Friday is the monthly U.S. -farm payrolls report for December. Economists expect the data to show 200,000 workers were added last month, which would be the smallest gain in two years.

Robust figures for U.S. weekly unemployment claims and private-sector employment on Thursday prompted a sell-off in Treasuries, which spilled into the European market.

Adding another drag on bonds were minutes from the Federal Reserve's latest meeting that showed policymakers do believe financial conditions are tight enough, which would warrant more rate rises than the market is currently pricing in.

A drop in the hourly earnings rate, which is currently at +5.1% year on year, could ignite another rally in bonds, analysts said.

"Delivery of a 4 (point anything) handle would really set the bond bulls going," ING strategists said.

"There's lots at stake as we face into this report."

(Reporting by Amanda Cooper; Editing by xxxxx)

((amanda.cooper@thomsonreuters.com; +442031978531; Twitter: https://twitter.com/a_coops1;))