Euro zone yields drop before German vote on spending plans, Fed

By Stefano Rebaudo

March 17 (Reuters) - Euro zone government bond yields dropped on Monday ahead of the German parliament vote on the country's spending plans on Tuesday in a week packed with central bank policy meetings.

Plans by chancellor-in-waiting Friedrich Merz to unleash a massive state borrowing programme were hit by last-minute legal challenges from the far-right Alternative for Germany, which challenged the vote at the constitutional court.

Meanwhile, Ifo Institute cut its forecast for the euro zone's biggest economy to 0.2% on Monday, citing subdued consumer sentiment and companies' reluctance to invest.

Spending plan will be a "positive" for its prized triple-A sovereign credit rating, S&P Global said on Wednesday.

Germany's 10-year government bond yields were down 5 basis points (bps) at 2.82%. They hit 2.938% last week, their highest level since October 2023, as expectations for more bond supply drove yields higher.

On Wednesday, the Federal Reserve and the Bank of Japan will announce their rate decisions, followed on Thursday by the Bank of England, the Riksbank and the Swiss National Bank.

BofA argued that the Fed will most likely stay on hold, "emphasizing patience over panic."

"U.S. rates may react to Fed communications with a curve flattening, reflecting the challenges of navigating sticky inflation and on-hold policy stance," said BofA rate strategist Mark Cabana.

"We would encourage clients to fade any curve flattening with the expectation that further declines in risk assets could push the market to price more Fed cuts."

There are "no guarantees" there will not be a recession in the U.S., although there could be an adjustment, Treasury Secretary Scott Bessent said in an interview on Sunday.

U.S. stock index futures took a hit on Monday after Bessent's comments.

Germany's 2-year yield, more sensitive to European Central Bank policy rates, fell one bp to 2.18%. It hit 2.319% two weeks ago, its highest since mid-January.

U.S. tariffs and Ukraine remained in focus after U.S. President Donald Trump said he would not create exemptions on steel and aluminium tariffs. He also said he planned to speak to Russian President Vladimir Putin on Tuesday and discuss ending the war in Ukraine.

Tariffs are supposed to boost inflation and depress growth, while a peace deal in Ukraine should be good for risky assets and the euro area economy.

Italy's 10-year yields dropped 6.5 bps to 3.50%. The yield gap between Italian and German bonds -- a market gauge of the risk premium investors demand to hold Italian debt - was at 105 bps.

The spread between French and German bonds stood at 67 bps, at the lower end of its recent range, after S&P left the French rating unchanged but revised its outlook to negative from stable.

(Reporting by Stefano Rebaudo, editing by Angus MacSwan)