Euro zone yields tumble on safe-haven demand, ECB policy path repricing

(Updates prices at 1450 GMT)

By Stefano Rebaudo

April 12 (Reuters) - Euro zone government bond yields dropped sharply on Friday as markets increased bets on future European Central Bank (ECB) rate cuts, while fears of a broadening of the Middle East conflict triggered bids for safe-haven assets.

The ECB said on Thursday it might cut rates soon but initially failed to trigger a repricing of market bets on future rate cuts after strong U.S. economic data led investors to reduce expectations for future monetary easing there.

On Friday, however, money markets increased bets on rate cuts by the central bank, pricing in more than 85 bps by year-end, from 75 bps expected late on Thursday.

Money markets also discounted an around 90% chance of a 25-basis-point first move by June.

Gold surged to a fresh peak, supported by safe-haven demand amid the tension in the Middle East.

Market participants said investors were closing some short positions on euro area government bonds opened during two weeks of strong U.S. data and hawkish remarks from Federal Reserve officials, as fears of a confrontation between Iran and Israel and the U.S. weighed on market sentiment.

"We do see geopolitical risks impacting markets a bit more than usual, with investors watching closely developments on Israel and Iran," Joost van Leenders, senior investment strategist at Van Lanschot Kempen, said.

Israeli Defence Minister Yoav Gallant said on Thursday Israel would respond directly to any attack by Iran. The Pentagon said it discussed with Gallant the United States' "iron-clad" commitment to Israel's security against threats from Iran and its proxies.

"Today's fall in yields is all about investors closing short positions they opened after strong U.S. economic data," said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors.

Germany's two-year government bond yield, more sensitive to the outlook of policy rates, dropped 12 basis points (bps) to 2.84%, after hitting a one-week low. The benchmark 10-year Bund yield fell to its lowest level in more than one week, last 13.7 bps lower at 2.33%.

The Italian 10-year bond yield was 14 bps lower at 3.72%. The gap between Italian and German 10-year borrowing costs – a gauge of risk premium investors ask to hold bonds of the euro area's most indebted countries – stood at 137 bps .

The ECB policy meeting on Thursday was relatively uneventful for the market as the central bank confirmed it would be data-dependent. (Reporting by Stefano Rebaudo, additional reporting Joice Alves; Editing by Peter Graff and Alison Williams)