UPDATE 3-Euro zone yields edge down, still near multi-year highs

(Recasts, updates prices)

By Samuel Indyk and Stefano Rebaudo

LONDON, March 9 (Reuters) - Euro zone bond yields edged down on Thursday but stayed close to the multi-year highs struck as investors revised upwards expectations for the European Central Bank rate-hiking path.

Borrowing costs retreated after U.S. data showed the number filing new claims for unemployment benefits increased more than expected last week, even if the underlying trend remained consistent with a tight labour market.

Upcoming U.S. job figures on Friday and consumer prices data next week will be pivotal in deciding whether rate hikes need to shift back to a higher gear, after the Fed delivered a 25-basis point hike in February.

In a second day in Congress on Wednesday, U.S. Federal Reserve Chair Jerome Powell reaffirmed his message for potentially faster rate rises, but said nothing had been decided ahead of the March 21-22 meeting, and economic data would be a major factor.

"After two days of Powell being in Congress, a 50 bps rate hike here later this month is clearly in play," Piet Haines Christiansen, fixed-income strategist at Danske Bank, said.

Markets are fully pricing in a 25-bps hike, with around a 70% probability of a larger 50-bps rate rise, Refinitiv data showed.

European Central Bank (ECB) rate expectations were also close to their highest levels, with the November 2023 ECB euro short-term rate forward at 4.05%, implying a deposit rate at around 4.15% by year-end.

Markets expect the ECB to raise rates by 50 bps this month, with a roughly 90% chance of another half-point rise at the meeting after that, Refinitiv data showed.

"If the Fed does go with 50 basis points in March, there will be some upward impact on ECB rate hike pricing, because it's not fully priced in yet," Lyn Graham-Taylor, senior rates strategist at Rabobank, said.

Germany's 10-year yield, the benchmark for the euro area, was last flat at 2.64%, just below 2.77%, its highest since 2011, reached earlier this month.

The country's two-year yield, more sensitive to changes in policy rate expectations, earlier rose by as much as 5 bps to 3.385%, its highest since the global financial crisis in 2008. It was last down 5 bps at 3.282%.

The German yield curve deepened its inversion, with the gap between 2- and 10-year yields dropping to as little as -72.6 bps, its lowest since 1992.

"We favour a flatter curve," Rabobank's Graham-Taylor said. "There have been some big moves over the last couple of months but there's no reason for why there isn't further to go."

A flattening yield curve typically signals that investors expect tighter interest rates in the near term, but are less confident in the economy's growth outlook.

On Thursday, French ECB policymaker Francois Villeroy de Galhau said inflation across the euro zone was still too high and remained the top priority for monetary policy.

A day before, Italian rate-setter Ignazio Visco, seen as a policy dove, criticised some fellow policy-makers for comments on future interest rates.

"There's obviously a bit of division opening up on the governing council, but given the data that's been coming in, a peak in rates around 4% makes a lot of sense," Graham-Taylor said.

Italy's 10-year yield fell 1.5 bps to 4.437%, keeping the closely watched spread between German and Italian 10-year yields around 175 bps. (Reporting by Samuel Indyk, additional reporting by Stefano Rebaudo; Editing by Sharon Singleton, Shounak Dasgupta and Barbara Lewis)