Euro area yields edge down after recent jump, await US data

By Stefano Rebaudo

Dec 20 (Reuters) - Euro zone government bond yields dropped slightly on Friday ahead of U.S. economic data later in the session that could provide further clues about the Federal Reserve easing path.

Euro area borrowing costs spent the previous session catching up with a jump in U.S. Treasury yields after their gap with German Bunds reached its widest point in over five years.

Germany's 10-year bond yield, the benchmark for the euro zone bloc, dropped one basis point (bp) to 2.30% and was on track for its third straight weekly rise.

Investors are bracing for "higher for longer" U.S. interest rates, after the Federal Reserve on Wednesday indicated that further monetary easing hinges on more progress in lowering stubbornly high inflation.

"A return to hikes is a low probability event, but the Fed will want to see further progress on inflation or an increase in the unemployment rate before resuming the easing cycle," said Tiffany Wilding, economist at PIMCO.

"The Fed believes the current rate, at 4.3% and change, is still restrictive and therefore maintained a cutting bias."

Markets priced in 41 bps of rate cuts in the U.S. by the end of 2025, which implies a 25 bps move and around a 60% chance of a second cut within the year, from around 50 bps right before the Fed statement.

They also discounted a European Central Bank deposit facility rate at 1.92% in July 2025, roughly in line with the levels seen before the Fed.

The U.S. Commerce Department's personal consumption expenditure (PCE) report will be released later in the session.

Investors were also grappling with the possibility of a U.S. government shutdown, following one in December 2018 and January 2019 during Donald Trump's first term in the White House.

"U.S. personal income and consumption data should continue to signal rising real incomes," said Paul Donovan, chief economist at UBS Wealth Management.

"The fact that household incomes are so strong, allowing consumption without use of savings or credit card debt, gives a solid foundation for US economic growth in 2025."

Germany's 2-year yield, more sensitive to expectations for ECB policy rates, fell 3.5 bps and was on track for a slight weekly fall.

Italy's 10-year yield, the benchmark for the euro area's periphery, was flat at 3.48%, with the yield gap between BTPs and Bunds at 117 bps.

French politics remained in the spotlight, with investors trying to assess whether a new government can tackle France's fiscal problems.

The yield spread between French government bonds and safe-haven Bunds - a gauge of the risk premium investors demand to hold French debt - was at 81 bps. It recently hit 90 bps, its highest in over 12 years.

The French Senate approved on Wednesday a special law designed to prevent any interruption of public services, by rolling over 2024 budget rules.

France's new prime minister, Francois Bayrou, said on Thursday he hoped to have a budget ready by mid-February. (Reporting by Stefano Rebaudo; Editing by Hugh Lawson)