REFILE-Euro zone bond yields drop as data amps up rate-cut expectations

(Refiles to fix typo in dateline with no change to text)

By Stefano Rebaudo and Amanda Cooper

LONDON/MILAN Jan 31 (Reuters) - Euro zone government bonds rallied sharply on Wednesday, sending German yields on their biggest one-day slide in four months, after soft data from both sides of the Atlantic reinforced the view that interest rates are on the verge of dropping.

U.S. data on wage growth and private-sector employment both undershot expectations, which supercharged a rally in short-dated Treasuries that fed into a fresh burst lower for European yields in afternoon trading.

The benchmark 10-year Bund yield, which is heading for its first monthly rise since September, dropped as much as 11.9 basis points, its largest daily fall since late September.

Earlier in the day, euro zone yields were already trading lower following inflation figures from Germany and France and dovish comments from European Central Bank officials.

"If we look at how European yields and European interest rate expectations responded to the Fed dot plot in December, there is a strong element of people viewing the ECB and the Fed are going to move at roughly the same time," OANDA strategist Craig Erlam said, referring to the Federal Reserve's projections for interest rates.

"There is some sort of alignment there ... when U.S. expectations change, we often see European expectations change too," Erlam said.

The Fed's policy projections in December unleashed a sizzling year-end rally across stocks and bonds.

The yield on the 10-year Bund was last down 11.7 bps at 2.156%, still set for a rise of 13 bps in January, while the two-year Schatz yield was down 12.7 bps at 2.399%, in line with a 15.2-bp drop in two-year Treasury yields to 4.207%.

Since the start of the year, markets have scaled back what many investors thought were overly ambitious bets on 2024 rate cuts from the ECB.

GERMAN DATA

Adding to the positive sentiment in the bond market earlier on was an expected fall in German retail sales in December, a fall in unemployment, and state figures that suggested inflation had resumed its downward trajectory.

"A lot of the decrease in headline (German) inflation is due to the most volatile component, food and energy," said Salomon Fiedler, economist at Berenberg.

"Core inflation shows a much less downward movement, while service inflation reveals a bit of an uptick year-on-year, which may be interesting as an indicator of wage pressure, which the ECB is watching closely," he added.

French consumer prices rose 3.4% in January, a touch above expectations, but inflation slowed from the previous month. This contrasted with data on Tuesday that showed a surprise rise in Spanish consumer prices.

Interest rate derivatives shifted to show traders were pricing in around 151 bps in ECB rate cuts this year, compared with 143 bps on Tuesday, based on ECB euro short-term rate (ESTR) forwards.

In a departure from his usual cautious tone, ECB policymaker Joachim Nagel, one of the Governing Council members that favours higher rates, on Tuesday said the ECB had "tamed that greedy beast" of inflation.

Analysts noted that data released on Tuesday showed euro area gross domestic product was flat in the fourth quarter and below the ECB's December staff projection estimate.

Upside surprises in Spain and Italy drove the overall resilience but also reaffirmed the divergence with the recessionary euro area core, including France and Germany, where the economy shrank in the final three months of 2023.

"Data showing a flattish economy in the euro area are the main drivers affecting expectations for future rate cuts and bond yields," said Joost van Leenders, senior investment strategist at Van Lanschot Kempen.

"Markets also looked at the recent comments from ECB officials (in the last few days), which were generally more dovish than a few weeks ago," he added.

Italy's 10-year government bond yield, the benchmark for the euro area's periphery, dropped 7 bps to 3.735%, leaving the risk premium of Italian 10-year debt over German at 156.3 bps, some 3.7 bps wider on the day.

(Additional reporting by Stefano Rebaudo in Milan; Editing by Andrew Cawthorne, Emelia Sithole-Matarise and Alison Williams) ;))