Investors increase bets on ECB rate cuts after US data

(Removes update tag in headline)

By Stefano Rebaudo and Alun John

Jan 12 (Reuters) - Investors increased their bets on future European Central Bank rate cuts on Friday, sending euro area government bond yields lower as data showed U.S. producer price inflation was weaker than expected in December.

Money markets priced in 155 basis points of policy rate reductions by year-end from 145 before the U.S. figures and 140 bps late on Thursday.

They also fully price a first ECB move in April , while the chances of a rate cut in March rose slightly to around 40%.

ECB chief economist Philip Lane said recent figures broadly confirmed current thinking at the central bank, but interest rate cuts are not a near-term topic of debate.

ECB euro-short term rate (ESTR) forwards priced in a 2.36% rate in December 2024, which implies a deposit facility rate at around 2.45% by year-end from the current 4%.

U.S. producer prices unexpectedly fell amid a decline in the cost of goods, while prices for services were unchanged, which bodes well for lower inflation in the months ahead.

Germany's 10-year yield, the benchmark for the euro area, was down 6 basis points (bps) at 2.14%.

Shorter dated euro zone yields - more sensitive to expectations for policy rates - dropped with the German 2-year yield down 11 bps to 2.52% and the Italian 2-year yield down 11.5 bps at 3.07%.

Analysts said the central banks' emphasis on data dependency makes markets more prone to volatility and overshoots more in the dovish direction, but some reckon money markets went too far in their bets on future ECB moves.

"We've seen a reassessment of very aggressive rate cut expectations priced in at the end of last year," said Joost van Leenders, senior investment strategist at Van Lanschot Kempen.

"I don't see many reasons for yields to fall sharply today, and I think it will be difficult for the ECB to deliver the number of rate cuts money markets are pricing unless the European economy will be weaker than expected," he added.

Italian government bonds outperformed their peers as highly indebted countries are set to benefit the most from rate cuts, with the 10-year yield falling 8 bps to 3.74%.

The gap between German and Italian 10-year yields dropped to 155.7 bps, its tightest in two weeks.

The expected jump in bond supply in the year's first weeks failed to affect yields significantly, which kept tracking money market bets on rate cuts.

"The January supply deluge in European government bonds is a well-known dynamic, and this week, the issuance wave crested," said Rohan Khanna, rate strategist at Barclays.

"The large order books pointed to cheap valuations and significant demand, allowing treasuries to issue larger sizes."

Markets passed through strong U.S. consumer prices, released on Thursday when short-dated U.S. Treasury yields briefly moved higher before ending the day down 10 bps.

"This market action seems to highlight the weight of evidence that would be required to dissuade the market from its current pricing of an aggressive rate-cutting path and decline in inflation," said analysts at Rabobank.

(Reporting by Stefano Rebaudo, editing by Barbara Lewis, Kirsten Donovan) ;))