May 27 (Reuters) - Euro zone bond yields dropped on

Tuesday after French inflation data came in weaker than

expected, while concerns about the potential adverse economic

impact of U.S. tariffs persisted.

Borrowing costs edged up on Monday as the U.S. backed away

from its threat to slap 50% tariffs on European imports, before

falling later in the session in the wake of U.S. Treasury market

worries about the effects of erratic U.S. trade policy.

French inflation fell to its lowest level since December

2020 in May, driven by a sharper decline in energy prices and a

slowdown in service costs.

Germany's 10-year government bond yield, the

euro area benchmark, dropped 2 basis points (bps) to 2.54% after

hitting 2.513%, its lowest level since May 8.

U.S. stock indexes rose on Tuesday after tensions between

the United States and the European Union cooled, favouring some

selloff in safe-haven bonds.

On the euro zone front, markets await more inflation data

from Germany, Italy and Spain on Friday.

The normalisation of interest rates in the euro zone is

probably not complete, European Central Bank (ECB) policymaker

Francois Villeroy de Galhau said on Tuesday.

However Austrian central bank governor Robert Holzmann, seen

as a hawk, called for a pause in rate cuts until September.

Markets are pricing in a 90% chance of an ECB 25 bps rate

cut next week. They also indicated a deposit facility rate at

1.67% in December, which implies an

additional easing move and an around 30% chance of a third cut

by year-end. The depo rate is currently at 2.25%.

Data showed that the euro zone economic sentiment improved

in May.

The benchmark 10-year U.S. Treasury yield was

down 5 bps to 4.46%, after a recent selloff on fiscal concerns.

A tax and spending bill which would saddle the U.S. with

more debt now heads to the Senate, with several senators saying

they would seek substantial changes over what is likely to be

weeks of debate.

Market participants expect U.S. regulators to revamp the

"supplementary leverage ratio", reducing the amount of cash

reserves banks must hold and encouraging them to play a larger

role in intermediating Treasury markets.

Italy's 10-year yield dropped one bp to 3.55%,

with the gap between Italian and German yields at

98 bps, after reaching 90.90 bps last week, its lowest level

since March 2021.