European debt yields steady, US yields rise as markets weigh rate outlook

(Updates at 1130 GMT)

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Italy's 10-yr bonds outperform German equivalents this week

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Germany's 2-yr yield at lowest in nearly 3 weeks

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U.S. and European rate differential diverge further

By Medha Singh

Nov 15 (Reuters) - Euro zone borrowing costs were little changed on Friday, while U.S. Treasury yields hovered near multi-month highs after hawkish remarks from Federal Reserve Chair Jerome Powell bolstered bets on higher-for-longer U.S. interest rates.

German 10-year bond yields, the benchmark for the euro zone bloc, was at 2.348%, on pace to end a second straight week mostly flat. Bond yields move inversely to prices.

The euro zone debt market has been struggling for direction since Donald Trump's U.S. election victory earlier this month.

European yields initially tracked U.S. rates higher, but the prospect of damage to an already fragile euro zone economy from Trump's proposed trade tariffs made the case for more rate cuts from the European Central Bank, thereby bringing yields lower. "While the size of any U.S. tariffs is highly uncertain, our analysis suggests that much of the growth drag will come from higher trade policy uncertainty, rather than the actual tariff increases themselves," Goldman Sachs economists led by Sven Jari Stehn said in a note. ECB's 25 bps rate cut last month was seen as insurance against unexpectedly low inflation, minutes of their Oct 16-17 meeting showed on Thursday.

Meanwhile, ECB board member Isabel Schnabel on Thursday said interest rate changes should remain the ECB's primary policy instrument and bond purchases, along with forward guidance, need to be used more sparingly. Money markets see a near-20% chance that the ECB would opt for a larger 50-bps rate cut next month, up from about 10% more than a week ago. Traders are near certain of at least a quarter-point reduction. Germany's two-year bond yield, which is more sensitive to ECB rate expectations, was up 1 bps at 2.114% after hitting its lowest since Oct. 24 at 2.091%.

"Trump tariffs could potentially lower (euro zone) growth more. Hence, the market is moving to price in more cuts from the ECB. This is reflected in the front end pricing differential between the Fed and the ECB and also in EUR/USD," said Mohit Kumar, strategist at Jefferies.

On the flip side, Federal Reserve Chair Jerome Powell indicated the U.S. central bank does not need to rush to cut rates amid a solid job market and sticky inflation.

That prompted investors to rein in bets on interest rate cuts next month, supporting U.S. yields and the dollar.

Elsewhere, Italy's 10-year yield dipped by 2 bps at 3.52%, the lowest since Oct. 30 and on set for the steepest fall in four weeks, outperforming their counterparts in German Bunds. The gap between Italian bonds and German Bunds, a gauge of the risk premium investors demand to hold Italian debt, stood at 118, the tightest in over four weeks. "We have been long Italian spreads as there are no idiosyncratic risks, with Meloni's government ticking all the right boxes, ECB is in a rate cutting mode and the broader risk sentiment is positive," Kumar said. (Reporting by Medha Singh in Bengaluru; Editing by Kim Coghill and Chizu Nomiyama )