*

Moves in euro zone bond yields muted

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European defence spending still in focus in "new playing

field"

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Traders pare ECB rate cut expectations

(Updates to European midday trade)

By Greta Rosen Fondahn

Feb 20 (Reuters) -

Longer-dated euro zone bond yields traded around their

highest in three weeks on Thursday, while geopolitics remained

in focus and markets awaited more clarity around the prospects

of increased defence spending in Europe.

U.S. President Donald Trump denounced Ukrainian President

Volodymyr Zelenskiy as a "dictator" on Wednesday and warned he

had to move quickly to secure peace or risk losing his country.

Germany's 10-year bond yield, the benchmark for

the euro zone bloc, rose for a fifth day to 2.558%, its highest

since January 30. The yield was last up 0.7 basis points (bps)

at 2.557%.

Yields move inversely to prices.

Euro zone bonds sold off this week on expectations that

European governments would ramp up issuance to fund bigger

defence spending.

While bond moves were muted on Thursday, 10-year German

Bund yields were on track for their biggest weekly jump since

early January, having risen about 13 bps on the week.

"The politicians seem to realise that Europe needs to

prepare for a situation where it cannot rely on the U.S. when it

comes to how much responsibility they will take for defending

Europe in the coming years," said Jussi Hiljanen, head of

European rates strategy at SEB.

"It's a new playing field altogether. It's going to be

reflected in the funding needs."

Hiljanen said however that there might be room for a

downwards correction of the past days' rise in longer-dated euro

zone yields, saying the moves were "maybe a bit exaggerated".

Italy's 10-year yield was largely unchanged at

3.633%, after touching its highest since January 29 on

Wednesday, and the gap between Italian and German yields

stood at 106.7 bps.

Traders also assessed minutes from the U.S. Federal

Reserve's January policy meeting, published on Wednesday,

showing that Fed officials discussed slowing or pausing the

ongoing drawdown of its balance sheet holdings. This sent U.S.

Treasury yields down.

PARED ECB BETS

Germany's two-year bond yield, which is more

sensitive to European Central Bank rate expectations, held

steady at 2.174%.

Investors have this week pared expectations on future ECB

rate cuts, knocking off about 5 bps from their bets. They now

price in about 72 bps of further policy easing this year.

ECB board member Isabel Schnabel told the Financial Times in

an interview published on Wednesday that the central bank should

start a discussion about whether further rate cuts are

necessary.

"Coming from her, such remarks should not surprise as

Schnabel has previously been estimating the neutral rate as high

as 3%," said ING analysts in a note.

"But what has changed in the meantime is the perception

of the fiscal backdrop, where aside from the immediate supply

implications, the prospect for larger defence investments also

argues for a more expansionary stance ahead," they added.

The ECB sees the

neutral rate

, which neither stimulates nor restricts growth, at between

1.75% and 2.25%. The bank's deposit rate is currently 2.75%.

Also in the mix, German

producer prices

rose less than expected in January, increasing by 0.5% on

the year, the federal statistics office reported on Thursday.

Analysts polled by Reuters had expected a 1.3% increase.