(Updates after euro zone inflation)

By Samuel Indyk

LONDON, July 1 (Reuters) - Euro zone government bond

yields fell slightly on Tuesday but remained within their recent

range as inflation in the bloc returned to the European Central

Bank's target level.

Inflation in the 20 nations sharing the euro currency crept

up to 2.0% in June from 1.9% a month earlier, in line with

expectations in a Reuters poll of economists.

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

the euro area, was last down 5 basis points at 2.55%. The

trading range for bund yields during June was the narrowest

since 2021, according to Commerzbank.

The ECB, having lowered borrowing costs eight times since

the middle of last year, has recently signalled it intends to

pause rate cuts with inflation back at target.

"They (the ECB) seem to be happy with policy for the time

being," said Jussi Hiljanen, chief rates strategist at SEB.

"The broad consensus is that the right thing to do in July

is wait and see and then look at the situation in September when

they have revised economic projections."

Money market traders are pricing in just a 5% chance of a

rate cut this month. Futures are pricing 26 basis points of

easing by the end of the year, implying one more quarter-point

rate cut.

Germany's monetary policy-sensitive two-year yield

was down 3 bps at 1.829%.

ECB President Christine Lagarde on Tuesday said the euro

zone is set to face increasing inflation volatility as she

kicked off the ECB Forum on Central Banking in Sintra, Portugal.

The event on Tuesday includes a panel discussion with

Lagarde alongside the heads of the Federal Reserve, Bank of

Japan, Bank of England and Bank of Korea.

Investors have recently increased their bets on easing from

the Fed given recent soft data and as U.S. President Donald

Trump has upped his pressure on the central bank to lower

interest rates.

The repricing of Fed interest rate expectations was having

an impact on euro zone bond yields, analysts said.

Italy's 10-year bond yield was down 5 bps at

3.445%, pushing the gap between Italian and German 10-year

yields to 88.5 bps.

The spread has narrowed significantly in recent months and

is close to its tightest in more than a decade.

"It's a pretty amazing development," SEB's Hiljanen said.

"The generally positive risk appetite is having a positive

impact for spreads."

Attention remained on the U.S. where Senate Republicans were

pushing to pass President Donald Trump's sweeping tax-cut and

spending bill that is set to add an expected $3.3 trillion to

the nation's debt pile.

Fiscal sustainability of the world's major economies has

been a key theme in recent weeks, as Germany recently approved

its draft budget for 2025 and a budget framework for 2026

including record investments to revive the economy.

Meanwhile, NATO members agreed to boost defence spending to

5% of gross domestic product, with deficits already ballooning

in nations such as France and Britain.

"While the fiscal expansion in Europe appears in the price,

the market is not giving due credit to the fiscal picture in the

U.S.," said Jefferies economist Mohit Kumar.

"Our view remains that H2 will see a lot of focus on fiscal

expansion which would put upward pressure on rates."