Euro zone bonds hold steady in 'wait and see' mode after sell-off

(Updates at 1555 GMT)

By Alun John

LONDON, Feb 7 (Reuters) - Euro zone government bond yields held steady on Wednesday as traders assessed the health of the area economy and waited for a major U.S. debt auction.

Germany's 10-year yield, the benchmark for the euro zone, was a whisker lower at 2.291%, up from 2.185% at the start of the month.

Data on Wednesday showed that German industrial production dropped in December, the latest sign of weakness in Europe's largest economy.

Still, European Central Bank board member Isabel Schnabel said the ECB must be patient with cutting interest rates as inflation could flare up again.

Neither German economic weakness nor the views of ECB hawks like Schnabel are new, but they illustrate the dilemma for rate setters as they decide when to begin interest rate cuts.

"We are in a bit of a wait-and-see mode right now. I believe that (10-year bonds) will likely range trade in the coming weeks as we need more of a catalyst to see a rally, but equally I don't see a massive sell-off from here," said Emmanouil Karimalis, European rates strategist at UBS.

"This will depend on communication and data, given that all the central banks are in data-dependent mode."

The U.S. Treasury will auction $42 billion worth of 10-year bonds later on Wednesday, a day after a sale of new three-year notes saw solid demand.

Investors have happily absorbed large amounts of European and U.S. bond supply this year but Wednesday's sale is a test of the appetite for longer-dated debt.

Germany's two-year yield, which is sensitive to ECB rate expectations, was flat at 2.605% while Italy's two-year yield rose 2 basis points (bps) to 3.264% .

Italy's 10-year yield was up less than 1 bp at 3.866% on Wednesday, leaving the closely watched spread between German and Italian 10-year yields slightly wider at 156 bps.

Current market pricing indicates roughly a two-thirds chance the ECB will begin cutting rates in April with a 25-basis-point move. It shows a larger chance of 50 bps of cuts by June.

Bond markets are currently very sensitive to changes in expectations of central banks' interest rate paths.

Yields in Europe rose sharply on Friday and again on Monday, tracking Treasuries after U.S. jobs data smartly beat expectations, spurring markets to largely give up on expectations that the Federal Reserve will be cutting by March.

The 18-basis-point move in the German benchmark yield was its biggest two-day rise since March 2023.

(Reporting by Alun John; additional reporting by Harry Robertson; editing by Ros Russell, Kirsten Donovan and Mark Heinrich)