Italy's debt risk premium hits 21-month low as traders eye rate cuts

(Updates at 1525 GMT)

By Harry Robertson and Stefano Rebaudo

Jan 26 (Reuters) - The risk premium investors demand to hold Italian debt fell to its lowest since April 2022 on Friday as investors boosted their bets on interest rate cuts slightly after the European Central Bank held rates steady on Thursday.

Yields ticked up somewhat after data showed that the Federal Reserve's preferred measure of inflation held steady at 2.6% in December, in line with economists' expectations, while consumer spending rose more than expected.

The gap between Italian and German 10-year bond yields fell to 149.3 basis points, the lowest since April 1, 2022, before widening slightly to 152 bps.

Italian bonds have benefited from investors' hopes that interest rates will fall sharply this year, reducing pressure on the euro zone's more indebted countries.

"The trends in Italy are broadly similar to what we see in the rest of Europe," said Roger Hallam, global head of rates at Vanguard. "The ECB policy risks are much lower."

Investors have also been drawn towards Italy's high yields and have grown less concerned about political volatility.

Germany's 10-year government bond yield, the euro area's benchmark, rose slightly after the U.S. data and was last up 3 bps at 2.31%, after falling 5 bps on Thursday.

The yield, which moves inversely to the price, hit a two-month high of 2.371% on Thursday before the ECB decision, but remains well below October's peak above 3%.

ECB euro short-term rate forwards showed that traders expect 141 basis points of rate cuts in 2024, from around 130 before the ECB press conference on Thursday.

Italy's 10-year government bond yield was last 2 bps higher at 3.842%, after falling 8 bps on Thursday.

Data which showed an index of pending U.S. home sales rose 8.3% in December, much more than the 1.5% expected, added to the upward pressure on yields.

The ECB held interest rates at a record-high 4% on Thursday and reaffirmed its commitment to fighting inflation.

Yet euro zone bond yields fell as investors noted that ECB President Christine Lagarde stressed the progress in tackling inflation and did not explicitly push back on market expectations for heavy rate cuts.

"When mentioning how March will be the occasion to decide on a pivot, it gives market satisfaction when it comes to its expectation of a cut around summertime," said Florian Ielpo, head of macro at Lombard Odier Asset Management.

Germany's 2-year bond yield, which is sensitive to interest rate expectations, was up 2 bps at 2.637%, after falling 9 bps on Thursday.

Money markets priced an 84% chance of a first 25 bps rate cut in April, up sharply from around 60% on Wednesday before the ECB and jobless claims data which suggested the U.S. labour market could be slowing on Thursday.

Euro zone inflation could fall faster than expected this year, a raft of surveys and indicators showed on Friday.

Yet ECB official Martins Kazaks, who is seen as a hawk on inflation, said on Friday the worst mistake would be cutting rates too early.

(Reporting by Harry Robertson and Stefano Rebaudo, editing by Hugh Lawson and Emelia Sithole-Matarise)