Euro zone bond yields drop as inflation bolsters ECB October rate cut bets

(Updates at 1449 GMT)

By Harry Robertson and Samuel Indyk

LONDON, Oct 1 (Reuters) - Euro zone bond yields dropped on Tuesday as data showed inflation in the bloc fell below the European Central Bank's 2% target in September, bolstering bets on an October rate cut from the European Central Bank.

Escalating geopolitical tensions also saw safe-haven German bund yields fall, while French bond yields declined as the French government said it planned targeted tax rises and spending cuts to narrow its gaping budget deficit.

Data on Tuesday showed euro zone inflation fell to 1.8% year-on-year in September - below the 2% level for the first time since mid-2021 - from 2.2% in August.

Germany's 10-year bond yield, the benchmark for the euro zone bloc, fell to as low as 2.011%, its lowest since January. It was last down 9.5 basis points (bps) to 2.038%. Yields move inversely to prices.

"It's a big change that has been taking place over the past few days, over the past week, when it comes to interest rate expectations," said Jussi Hiljanen, head of European rates strategy at lender SEB.

"Basically an October rate cut has been baked into the pricing. That has been having an impact on yields."

Traders in money markets on Tuesday saw a more than 90% chance of a 25 bp cut from the ECB in October, up from 75% on Monday and 45% a week ago. The ECB cut rates by 25 bps in June and again in September, taking them to 3.5%.

Finnish ECB policymaker Olli Rehn said on Tuesday that the inflation slowdown means there are now more reasons to justify an interest rate cut at the October meeting.

President Christine Lagarde on Monday said the ECB will take into account the drop in inflation when it meets later this month.

Italy's 10-year yield fell 10 bps to 3.364%, while the gap between Italian and German yields stood at 132 bps.

Germany's two-year bond yield was down 5 bps at 2.022%, having briefly dropped below 2% for the first time since December 2022.

France's 10-year bond yield fell 11 bps to 2.813%, its biggest one-day drop since May.

French media reports highlighting that the new government was considering tax hikes of between 15 to 18 billion euros were supporting French bonds on Tuesday, according to Emmanouil Karimalis, macro rates strategist at UBS.

"This has been supportive for long-end OATs today and contributed to the overall momentum," Karimalis said.

The spread between French and German 10-year yields narrowed by 2 bps to 77 bps.

Markets were also keeping a close eye on geopolitical developments in the Middle East after U.S. officials said the U.S. had indications that Iran is preparing to imminently launch a ballistic missile attack against Israel.

"What we're seeing is a broad-based knee-jerk risk-off move," said Michael Brown, senior research strategist at Pepperstone, as safe-haven German bunds rose.

"The market will continue to display a heightened sensitivity to geopolitical news flow for the time being." (Reporting by Harry Robertson and Samuel Indyk; Editing by Andrew Heavens, Christina Fincher and Jane Merriman)