German two-year yields set for weekly drop as strong euro could shape ECB path

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Money markets price in a 30% chance of an ECB rate cut in 2026

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Borrowing costs little changed after euro zone economic data

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Risks of a second China shock in ECB's focus, Deutsche Bank says

By Stefano Rebaudo

Jan 30 (Reuters) - German two-year government bond yields were set on Friday for a weekly drop, with investors betting the European Central Bank will factor in the deflationary drag from a stronger euro as ?it shapes its policy outlook.

The euro hit a 4-1/2-year-high against the dollar on Tuesday after President Donald Trump said the U.S. currency's value was "great", when asked whether ?he thought it had declined too much.

German two-year yields, which are more sensitive to expectations for policy rates, were ?up 0.5 basis points at 2.06% and on track for a 6.5-bp weekly decline, ?the biggest since October.

Money markets priced ?in around a 30% chance of a rate cut in September, up from less than 10% a week ago, while indicating a 20% probability of ?a rate hike in April 2027, down from 50%.

ECB POLICY MEETING ?IN FOCUS

Investors are awaiting next week's ECB monetary policy meeting.

"Policy rates might be unchanged again in February, but the ECB has no shortage of issues to ponder," said Mark Wall, chief European economist ?at Deutsche Bank Research.

"Is a 'Second China Shock' a more ?significant concern ?to Europe than U.S. tariffs? And is currency stability becoming a challenge to the smooth transmission of monetary policy?"

Investors have been worried that the strength of the euro could amplify the deflationary impact of China's export ?machine and become the catalyst that jolts the ECB out of its "good place" and into further interest rate cuts.

Economists also flagged that geopolitical risks remain a major theme this year, meaning the ECB has to stay nimble and able to respond quickly.

Long-dated U.S. Treasuries were sold in early London trading on Friday, with benchmark 10-year yields up 3 bps at 4.26%, on speculation Trump would nominate former Federal Reserve Governor Kevin Warsh to head the U.S. central bank and that ?he would ?push to reduce the amount of bonds the bank owns.

DATA CONFIRM EURO ZONE RESILIENCE

Germany's 10-year government bond yield, the euro zone's benchmark, rose 1.5 bps to 2.85%.

Borrowing costs were little changed after solid ?economic data on Friday showed that euro zone economies grew at a modest but steady pace, while inflation stood at 2% in Germany's most populous state, North Rhine-Westphalia.

"We have seen some temporary good performances in Germany quickly reverse in the past few years, so the big question now is whether this will be repeated in the coming quarters," said Franziska Palmas, senior Europe economist at Capital Economics.

The 30-year yield was up 2.5 bps at 3.50%. It rose to 3.556% in late December, its highest since summer 2011.

The yield gap ?between French government bonds and safe-haven Bunds - a market gauge of the risk premium investors demand to hold French debt - widened to 58 bps after hitting a fresh 19-month low at 55.50 bps, on Monday.

Italy's 10-year government bond yields rose 2 bps to 3.47%. The gap versus Bunds was at ?61 bps, after tightening to 53.50 in mid-January, its lowest level since August 2008. (Reporting by Stefano Rebaudo. Editing by Mark Potter)