Euro zone yields drop to multi-week lows, await ECB neutral rate estimate

Feb 5 (Reuters) - Euro area government bond yields dropped to multi-week lows on Wednesday as investors focused on the possible disinflationary impact of U.S. tariffs, which could prompt the European Central Bank to accelerate interest rate cuts.

Investors are also awaiting updated estimates of the so-called neutral rate (R*) that ECB staff will publish on Friday.

R* is the interest rate level that keeps the economy in balance, with full employment and stable inflation, and is usually the rate target for central banks.

"Friday's revision could conclude a tighter range with a higher minimum," Citi said, recalling that in Davos, ECB President Christine Lagarde had indicated 2.25% and 1.75%.

Money markets priced in an ECB deposit facility rate of 1.85% in December, compared to 1.95% late on Friday before the tariff announcements by U.S. President Donald Trump.

Some analysts argue that the demand shock facing euro zone exporters in the event of higher U.S. import duties is likely to be more significant than any inflationary effect caused by potential retaliatory tariffs from the European Union.

Germany's 10-year bond yield, the benchmark for the euro zone bloc, fell 4 basis points (bps) to 2.354%, after touching its lowest level since Jan. 2 at 2.345%.

German two-year yields, more sensitive to ECB rate expectations, were down one bp at 2.047%. It hit 2.01% on Monday, its lowest since Dec. 20.

The ECB is confident that inflation will slow to near 2% this year, but there are still uncertainties, particularly surrounding the geopolitical situation, the bank's vice president, Luis de Guindos, said in an interview.

Economists said investors were not taking Trump's comments about the U.S. taking over Gaza seriously, but flagged that any move of that kind would heighten tensions in the Middle East, boosting oil prices.

The yield spread between French OATs and German Bunds - a market gauge of the risk premium investors demand to hold French debt - held steady at 71.6 bps.

The spread had widened to around 90 bps, its highest since 2012, in mid-January amid fears that France would be unable to cut its growing budget deficit.

French far-right leader Jordan Bardella suggested on Tuesday his party would probably not back no-confidence motions against Francois Bayrou's minority government, which rammed the 2025 budget bill through parliament on Monday.

"An ongoing OAT recovery should be used to add to structural shorts in the semi-core complex against Iberia and European Union (bonds)," said Michael Leister, analyst at Commerzbank.

Semi-core euro area bonds include those from France, Belgium and the Netherlands.

Italy's 10-year yield dropped 5 bps to 3.446%. Earlier in the day it touched 3.43%, its lowest since Dec. 18.

The gap between Italian and German yields stood at 108.2 bps. (Reporting by Stefano Rebaudo and Greta Rosen Fondahn Editing by Alex Richardson and Gareth Jones)

Citigroup