June 13 (Reuters) -

German government bond yields fell while Italian and French

borrowing costs pared gains after

U.S. data

showed an unexpected drop in producer prices, supporting

expectations that central banks will ease their monetary policy.

The euro zone's borrowing costs were edging up right

before the U.S. figures with investors balancing recent weak

U.S. consumer price inflation data against Federal Reserve

policymakers' median projection, which now sees only one

interest rate cut this year, down from three in March.

Yields in the bloc recorded their biggest daily fall since

mid-May on Wednesday after economic data showed U.S. inflation

was softer than expected.

Money markets priced in 38 bps of further European Central

Bank rate cuts in 2024, implying a second cut fully priced in

and a roughly 50% chance of a third this year

. They discounted 49 bps of Fed cuts from 44

bps before data.

"We expect continued good readings on inflation to enable

the Fed to start cutting then, but the risk continues to be that

the disinflation path is bumpy," said Xiao Cui, senior economist

at Pictet Wealth Management, referring to the outcome of the Fed

policy meeting.

Germany's 10-year yield, the benchmark for

the euro area, fell 2 basis points (bps) to 2.52%. It hit 2.707%

at the end of May, its highest level since mid-November.

The spread between French and German yields -

a gauge of the risk premium investors demand to hold French

government bonds - was close to its highest level in around 15

months after French President Emmanuel Macron urged rival

parties on Wednesday to join his electoral alliance against

Marine Le Pen's far-right National Rally.

French financial assets are saddled with political

uncertainty and investor fears that a far-right government, if

it wins power in the upcoming snap parliamentary election, could

worsen France's long-term fiscal sustainability.

The French spread widened to 65.5 bps; it hit

66.9 earlier this week, its widest level since March 2023. OATs

10-year yield rose 1.5 bps to 3.17%.

Gains by the far right in voting for the European Parliament

on Sunday may complicate European Union attempts to deepen

integration, increasing the risk premium investors demand to

hold bonds of the most indebted countries.

Italy's 10-year yield rose one bp to 3.93%,

with the gap between Italian and German yields

widening 5 bps to 142 bps.

Germany's 2-year government bond yield, more

sensitive to policy rate expectations, was down 3 bps at 2.94%.

In the euro zone, ECB policymakers have recently sounded

cautious about the disinflation process. ECB vice-president Luis

de Guindos said the central bank must move "very slowly" in

reducing rates, and chief economist Philip Lane argued the ECB

should wait with its next cut until uncertainty recedes.