Euro zone yields drop after economic data, ECB's Nagel comments

(Adds analyst comments)

By Stefano Rebaudo

Jan 31 (Reuters) - Euro zone government bond yields dropped on Wednesday after mixed economic data from Germany and France and dovish comments from European Central Bank officials.

German retail sales fell unexpectedly in December, unemployment dropped, and state figures suggested that inflation had resumed its downward trajectory.

"A lot of the decrease in headline (German) inflation is due to the most volatile component, food and energy," said Salomon Fiedler, economist at Berenberg.

"Core inflation shows a much less downward movement, while service inflation reveals a bit of an uptick year-on-year, which may be interesting as an indicator of wage pressure, which the ECB is watching closely," he added.

French consumer prices rose 3.4% in January, a touch above expectations, but inflation slowed from the previous month.

Germany's 10-year government bond yield, the benchmark for the euro area, fell 5 basis points to 2.23%.

Still, it was on track to record its first monthly rise -- it was last up 20 bps -- since September 2023 as markets scaled back what investors deemed overly ambitious bets on policy rate reductions at the end of 2023.

The Spanish consumer price index surprised to the upside on Tuesday, driving euro area bond yields up.

ECB euro short-term rate (ESTR) forwards priced in 143 bps of rate cuts in 2024 from around 140 bps late Tuesday, including a 95% chance of a first move by April .

"Data showing a flattish economy in the euro area are the main drivers affecting expectations for future rate cuts and bond yields," said Joost van Leenders, senior investment strategist at Van Lanschot Kempen.

"Markets also looked at the recent comments from ECB officials (in the last few days), which were generally more dovish than a few weeks ago," he added.

The ECB has tamed the "greedy beast" of inflation, policymaker Joachim Nagel, seen as a hawk, said on Tuesday, in a departure from his usual cautious tone.

Market participants label as hawks central bank officials who advocate a tight monetary policy to control inflation, while doves are more focused on economic growth and the labour market.

Analysts flagged that data released on Tuesday showed that euro area gross domestic product (GDP) was flat in the fourth quarter and below the ECB's December staff projection estimate.

Upside surprises in Spain and Italy drove the overall resilience but also reaffirmed the divergence with the recessionary euro area core, including France and Germany.

The German economy shrank in the final three months of 2023, prompting economists to warn on Tuesday of another recession.

Italy's 10-year government bond yield, the benchmark for the euro area's periphery, dropped 3.5 bps to 3.78%, with the gap between Italian and German 10-year yields widening to 151 bps.

Bond prices of highly indebted countries have particularly benefited from the ECB's very gradual wind-down of the Pandemic Emergency Purchase Programme (PEPP) reinvestments announced last December.

(Reporting by Stefano Rebaudo, editing by Andrew Cawthorne and Emelia Sithole-Matarise) ;))