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German 10-year yield down xx bps

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Euro zone composite PMI stays in contraction

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ECB policymakers differ on Dec. rate cut size

(Updates at 1013 GMT)

By Samuel Indyk

LONDON, Oct 24 (Reuters) - Euro zone government bond

yields fell on Thursday after business activity data confirmed

that growth is set to remain sluggish in the fourth quarter,

supporting the case for further European Central Bank rate cuts.

HCOB's preliminary composite purchasing managers' index rose

to 49.7 in October from 49.6 in September, but remained below

the 50 threshold that separates growth from contraction for a

second straight month.

A Reuters poll of economists forecast a rise to 49.8.

"The PMI figures have contributed to the view that price

pressures are easing and the labour market is weakening," said

Jussi Hiljanen, head of European rates strategy at lender SEB.

"The market is continuing to pivot towards a 50 basis point

move (from the ECB) in December."

Traders are fully pricing a 25 basis point (bp) rate cut at

the central bank's next policy meeting in December, and around a

43% chance of a larger 50 bp move.

ECB officials, while signalling support for lower borrowing

costs, have differed on their views on the pace of rate cuts and

the endpoint for interest rates.

Portuguese rate-setter Mario Centeno said rates could be cut

by 50 bps at the central bank's December meeting. Hawkish policy

maker Robert Holzmann said another 25 bp reduction was not ruled

out but also not decided yet.

ECB President Christine Lagarde, speaking on Wednesday,

sounded more cautious when deciding on further interest rate

reductions, saying the central bank must take its cue from

incoming data.

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

euro zone, was down 4 bps at 2.273%. It rose to 2.334% on

Tuesday, its highest since Sept. 3. Yields move inversely with

prices.

The two-year yield, which is more sensitive to

changes in interest rate expectations, fell 4 bps to 2.096%.

Money markets currently see the ECB deposit rate bottoming

out at about 1.8% in the second half of next year, as growth

remains sluggish.

"If and when we get continued weak data in the coming

months, I think the market will push the terminal rate pricing

towards 1.5%," SEB's Hiljanen said.

"This has implications for long-end yields because, for as

long as we're in the environment where terminal rate

expectations are creeping lower, it's difficult to build any

sustainable uptrend in long-end yields."

Italian policymaker Fabio Panetta said on Wednesday that the

ECB may need to cut interest rates beyond the neutral rate to a

level low enough to stimulate the economy.

Italy's 10-year yield, the benchmark for the

more indebted countries in the euro zone's periphery, fell 4.5

bps to 3.484%, keeping the spread between Italy and Germany's

10-year yields steady at about 120 bps.

Britain's bonds underperformed their European counterparts

after the Guardian reported that Finance Minister Rachel Reeves

was to announce a change to the country's fiscal rules to unlock

additional funds for investment spending in next week's budget.

Britain's 10-year gilt yield was up 3 bps at

4.231%, with the gap between German and UK 10-year yields

widening as far as 198 bps.