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Euro zone bond yields fall as German inflation slows

By Harry Robertson

LONDON, Jan 3 (Reuters) - Euro zone government bond yields fell on Tuesday after regional German inflation data suggested price pressures in Europe's biggest economy cooled sharply in December.

Germany's 10-year government bond yield rose early in the session but then dropped after the regional data was released and was last down 8 basis points (bps) to 2.371%. It fell 12 bps on Monday as investors anticipated a slowdown in euro zone inflation. Yields move inversely to prices.

Data released at 0900 GMT showed that inflation slowed sharply in the populous German states of Bavaria and Baden-Wurttemberg in December.

The figures came ahead of the release of data for the whole of Germany, due at 1300 GMT on Tuesday, which themselves come before euro zone-wide data is released on Friday.

German headline inflation, adjusted to compare with the rest of the euro zone, is expected to slow to 10.7% year-on-year in December, from 11.3% in November, in part because of a government-backed discount on energy bills.

Italy's 10-year bond yield was down 8 bps to 4.482% on Tuesday, after falling 15 bps the previous day. The spread between Germany's and Italy's 10-year bond yields narrowed slightly to 210 bps.

Florian Ielpo, head of global macro at Lombard Odier, said the regional German numbers increased expectations that the European Central Bank (ECB) might be able to raise interest rates by less than expected, reducing pressure on bonds.

Yet he added: "Let's not rush to conclusions. We've had two inflation reports in Europe showing declining inflation, which is great but is pretty much reflective of what's happening in energy markets." Energy prices have fallen sharply in recent months, in part because of mild weather.

"It's the job of the ECB to be worried about wage or demand driven inflation," Ielpo said.

Comments from ECB policymakers in recent days have bolstered bets that more rate hikes are coming. The ECB raised rates from -0.5% in July 2022 to 2% in December, hammering European government bonds.

ECB chief Christine Lagarde said euro zone wages are rising quicker than expected. Joachim Nagel, president of Germany's central bank, said the ECB should continue tightening its monetary policy to curb inflation expectations.

Germany's 2-year bond yield, which is sensitive to interest rate expectations, fell 2 bps to 2.667% on Tuesday, after rising earlier in the session.

Francesco Maria Di Bella, fixed income strategist at UniCredit, said it was hard to read too much into market moves. "Strong fluctuations are ... due to the fact liquidity is still low," he said.

The euro zone-wide data inflation data, due on Friday, is expected to show that prices rose 9.7% in the year through December, down from a 10.1% rate the previous month. (Reporting by Harry Robertson; editing by David Evans)