German 10-year yield and Italian spread drop ahead of ECB meeting

(Adds comments from Unicredit and Citi, background)

By Samuel Indyk and Stefano Rebaudo

LONDON, March 5 (Reuters) - Germany's 10-year bond yield plunged on Tuesday while the spread between Italian and German 10-year yields hit its tightest since February 2022 as markets braced for pivotal risk events including the European Central Bank's policy announcement.

The ECB is seen leaving its main policy rates unchanged on Thursday, with markets watching for clues from President Christine Lagarde on when interest rate cuts might begin.

Stickier inflation in Europe and the United States and a more robust global growth outlook have seen markets scale back expectations for easing this year.

"Investors probably hope to hear a more dovish tone from the (ECB) Governing Council," said Francesco Maria Di Bella, rate strategist at Unicredit.

"The (bond) sell-off that took place in February has also made bond valuations more attractive, especially in a year when central banks are expected to cut rates," he added.

Money market traders now expect ECB policy easing to begin in June, with around 4 basis points (bps) of cuts priced in for April, implying just a 16% chance of lower interest rates then.

At the start of the year, an April rate cut was almost fully priced in.

They are also pricing in 95 bps of easing this year, down from around 150 bps in January.

"Given the massive repricing that we've recently seen, it would take quite a hawkish rhetoric from the ECB to push markets further in the hawkish direction," said Jussi Hiljanen, head of rates strategy at lender SEB.

Germany's 10-year bond yield, the euro area's benchmark, was last down 9 bps, in its biggest daily fall since Jan. 31, at 2.293%, its lowest since mid-February. It hit its highest since November last Thursday at 2.513%.

The two-year yield, which is sensitive to changes in policy rate expectations, was last down 6 bps at 2.83%.

HCOB's composite Purchasing Managers' Index (PMI) for the bloc, rose to 49.2 in February, ahead of a preliminary 48.9 estimate. Analysts said figures were consistent with expectations for economic stagnation in the first quarter.

Meanwhile, Italy's 10-year bond yield, the benchmark for the euro zone's periphery, was last down 12 bps to 3.70%, pushing the gap between German and Italian 10-year yields to hit 135 bps, its tightest since February 2022.

Christian Schulz, European economist at Citi, flagged that "jointly the composite PMI in Italy and Spain has been above 50 for the past two months, pointing to the fastest growth momentum since May last year and far outperforming core countries."

"We believe the periphery overperformance displays structural features and we expect it to continue into the next couple of years," he argued in a research note.

Economic growth -- other things being equal -- lowers the closely watched public debt-to-GDP ratio.

SEB's Hiljanen mentioned the expected start of a cutting cycle. "The lower yields become in Italy, the more sustainable becomes the debt situation," Hiljanen said.

Analysts said the yield gap is also supported by the ECB commitment to avoid the so-called fragmentation -- an excessive spread widening which could hamper the transmission of the monetary policy across the euro area.

Markets will digest Britain's Spring Budget on Wednesday, the first leg of Federal Reserve Chair Jerome Powell's semi-annual testimony to Congress, and a raft of data, including the U.S. payrolls report on Friday.

(Reporting by Samuel Indyk and Stefano Rebaudo, editing by Ed Osmond, Mark Potter and Jonathan Oatis)