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Moves in euro zone bond yields muted

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European defence spending still in focus

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Traders pared ECB rate cut expectations on Wednesday

(Updates prices before European close)

By Greta Rosen Fondahn

Feb 20 (Reuters) - Longer-dated euro zone bond yields

dipped from 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, was last down 1 basis point (bp) at 2.536%,

after earlier hitting its highest since January 30 at 2.563%.

Yields move inversely to prices.

Euro zone bonds have 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 11 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 down 2 bps at 3.618%,

after touching its highest since January 29 on Wednesday at

3.644%.

The gap between Italian and German yields

stood at 108 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, fell 3 bps

to 2.148%.

It rose 4 bps on Wednesday after ECB board member Isabel

Schnabel told the Financial Times 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.