GLOBAL MARKETS-Bonds rally, dollar firms as traders ponder rate cuts

(Updates at 0913 GMT)

By Yoruk Bahceli

Oct 1 (Reuters) - Government bonds rallied on Tuesday as euro zone inflation data boosted the case for faster European Central Bank rate cuts but the dollar firmed after comments by U.S. Federal Reserve Chair Jerome Powell scuppered bets on a second big rate reduction.

Oil prices slumped even as Middle East tensions escalated after Israel's ground incursion in Lebanon appeared to be getting underway early on Tuesday. .

Euro zone inflation data helped the bond rally as it came in below the ECB's target, boosting the case for speedier rate cuts that traders have been betting on.

Germany's 10-year bond yield dropped to its lowest since January. U.S. Treasury 10-year yields were last down 6 basis points at 3.74%.

"The dovish repricing of ECB expectations (is) continuing as markets increasingly price an October cut," said Michael Brown, senior strategist at Pepperstone.

The U.S. dollar was 0.2% higher against a basket of currencies as traders reckoned the Fed was now more likely to cut rates by 25 bps rather than 50 bps in November.

European stocks, meanwhile, edged marginally higher with the STOXX 600 index up 0.2%. But U.S. stock futures indices were flat to 0.3% lower.

HURRY OR NOT?

Inflation data showed euro zone price growth dropped to 1.8% in September, below expectations and the lowest since mid-2021.

It follows national prints that came in below expectations and after ECB President Christine Lagarde said on Monday the bank was increasingly confident inflation would fall to its 2% target.

Lagarde said this would be reflected in the ECB's next policy move, a hint at a rate cut that traders have been betting on since business activity data weakened the bloc's growth outlook last week.

That contrasted with the United States, where Fed Chair Powell indicated on Monday the central bank would likely stick to quarter-percentage-point cuts following a big 50 bps move last month after new data boosted confidence in economic growth and consumer spending.

"This is not a committee that feels like it is in a hurry to cut rates quickly," Powell said.

Traders on Tuesday were pricing in a 40% probability of a 50-bp Fed cut next month, down from 53% on Friday. They anticipate 70 bps of easing this year.

Given the Fed's current focus on the labour market, Tuesday's data on job openings for August and the ISM manufacturing survey for September will be important for rate expectations and the dollar, said economist Kristina Clifton at the Commonwealth Bank of Australia.

On Friday, U.S. non-farm payrolls data will provide further clarity on the state of the labour market.

In commodities, oil prices dropped on Tuesday given the prospect of additional supply amid lacklustre global demand growth, offsetting worries that an escalating Middle East conflict could disrupt exports in the key producing region.

Israel said intense fighting erupted with Hezbollah in south Lebanon on Tuesday after its paratroops and commandos launched raids there, at the start of a ground incursion following devastating airstrikes against Hezbollah's leadership.

Brent crude futures dropped 2.3% to $70.03 a barrel. U.S. West Texas Intermediate crude futures were down 2.5% at $66.46 a barrel.

"There's been relatively little impact from Middle East news flow, which is perhaps unsurprising with the market seemingly having become somewhat immune to developments in the region," said Pepperstone's Brown.

Elsewhere, the yen steadied close to the middle of its range against the dollar over the past month, after a volatile two days as traders sized up Japan's incoming prime minister and his cabinet.

Earlier, Japan's Nikkei stock index rose nearly 2% on a softer yen after shedding 4.8% on Monday.

Spot gold was 0.5% higher around $2,647 per ounce, not far from the record high of $2,685.42 touched on Thursday.

Gold rose 13% over July-September, its best quarterly performance in over four years.

(Reporting by Yoruk Bahceli and Ankur Banerjee; Editing by Christopher Cushing, Sam Holmes and Emelia Sithole-Matarise)