Euro zone yields fall as investors ditch bets on ECB hikes

* German 2-year yields at largest discount to US since September

* Money markets now price one ECB rate hike by October instead of two last week

* Germany sold ?3.087 billion of 2-year debt at a 2.57% average yield (Updates with comment, adds monthly business surveys, refreshes prices)

By Amanda Cooper

LONDON, June 23 (Reuters) - Euro zone sovereign bond yields fell for a second day on Tuesday as investors pared bets on further European Central Bank rate rises, while expectations grew that the Federal Reserve would keep hiking.

German 2-year bond prices rallied sharply in late trade on Monday, which sent yields down by the most in two weeks, after ECB President Christine Lagarde told the European Parliament there was no evidence of the kind of pickup in inflation that would warrant more forceful policy action.

Schatz yields fell nearly 5 basis points on the day to 2.595% on Monday, compared with 2-year U.S. Treasury yields , which shot up 5 bps to 4.236%, the highest in 16 months, as traders ramped up their bets on the Fed raising interest rates in the months to come.

On Tuesday, 2-year German yields were down 3 bps on the day at 2.564%, compared with 4.192% for their U.S. counterparts.

This has brought the discount the German government pays to borrow for two years to that paid by the U.S. to around 163 basis points, the largest since September 2025, and well beyond the about 113-bps gap two months ago.

Germany also sold ?3.087 billion ($3.52 billion) in 2-year Schatz debt on Tuesday at an average yield of 2.57%, the lowest for this maturity since April, and with a bid-to-cover ratio of 1.9, which was the highest since January.

A steady stream of robust U.S. economic data and a shift in rhetoric from the Fed under new Chair Kevin Warsh to focus more on containing inflation have dented demand for Treasuries and pushed up the dollar in the last week or so.

With the oil price now below $80 a barrel and falling, thanks to flows of crude and products ramping up through the Strait of Hormuz, expectations for the ECB to raise rates aggressively to anchor inflation have receded. Meanwhile, money markets showed traders believe euro zone rates will end this year around 30 basis points higher than where they are now, with the next hike coming in October. Last week, there were two hikes priced in.

"We would read the comments as suggesting that no more hikes are required, if oil prices were to stay at similar or lower levels. That has been our view since the last ECB meeting, that the ECB would not need to hike any more in this business cycle," Jefferies strategist Mohit Kumar said.

Earlier on Tuesday, a survey of the euro zone private sector showed business activity shrank for a third month in June, although at a slower pace, while input costs rose at their slowest pace since just before the outbreak of war in late February - in theory taking some pressure off ECB policymakers.

"For the ECB, this is dovish news. If the environment which the PMI paints persists in the coming weeks, it will deter the ECB from hiking forcefully, as the inflationary environment would not be strong enough to require significant monetary tightening," ING economist Bert Colijn said.

ECB chief economist Philip Lane on Tuesday said euro zone inflation could stay high for some time, something echoed by fellow policymaker Peter Kazimir, who said damage from the conflict in the Middle East cannot be removed overnight and the central bank still had work to do.

Benchmark 10-year Bund yields were down 4 bps at 2.912%, while Italian 10-year debt was yielding 3.65%, down 3 bps.

One-year euro zone inflation swaps have collapsed to around 2.52% this week, which is still above the ECB's 2% rate, but well beneath late May's three-year peak of nearly 4%.

($1 = 0.8774 euros) (Reporting by Amanda Cooper; Editing by Jamie Freed and Jan Harvey)