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Traders digest new U.S. tariffs

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U.S. pauses military aid to Ukraine

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ECB expected to deliver rate cut this week

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U.S. economy in focus after ISM data

(Updates with late European trading)

By Lucy Raitano

LONDON, March 4 (Reuters) - Euro zone bond yields mostly

fell on Tuesday as traders weighed the prospect of higher

European borrowing to fund defence spending with new U.S.

tariffs on Mexico and Canada and a doubling of duties on Chinese

goods.

The European Central Bank meets on Thursday and is expected

to deliver a 25-bp rate cut, an expectation bolstered by euro

zone inflation figures on Monday.

Germany's 10-year bond yield, the euro zone's

benchmark, fell as much as 6 basis points (bps), but was last

down 1 basis point to 2.485%.

The drop in yields was more evident in shorter-dated bonds,

which are more sensitive to interest rate policy. Germany's

2-year bond yield fell 5.5 bps to 2.013%, having

earlier hit its lowest since December 12 at 1.986%.

Morgan Stanley analysts on Tuesday changed their call for

ECB rate expectations, now seeing the central bank cutting rates

again in April, spurred by weak inflation and growth data.

Longer-dated yields rose sharply on Monday, as traders

reacted to the prospect of an increase in government spending on

defence, as European leaders rallied around Ukraine.

On Tuesday, the European Commission floated the possibility

of new joint European Union borrowing to fund an expansion of

defence capabilities - something that will come under discussion

at Thursday's special summit.

"Europe will try to come up with inventive ways of funding

this," said Nathan Sweeney, CIO of multi-asset solutions at

Marlborough, citing the option of using seized Russian assets.

"If they go down that route it has less implications for the

bond market."

Germany's central bank on Tuesday proposed a reform of the

country's constitutionally enshrined cap on borrowing, which

could give the government up to 220 billion euros ($231.46

billion) worth of extra cash for defence and investment this

decade.

"There's a lot of uncertainty and we're trying to square off

German defence spending plans, which we suppose should result in

higher bond yields and higher borrowing," said Kenneth Broux,

head of corporate research, FX and rates at Societe Generale

"On the flipside we have the situation on the ground in

Ukraine where there doesn't seem to be any guarantee that the

U.S. will backstop any peacekeeping efforts by European allies,"

he added.

Yields on 30-year German bonds, which on Monday

rose nearly 12 bps, were up 3.5 bps on Tuesday at 2.835%.

U.S. Treasury yields dropped on Tuesday,

extending Monday's decline following the latest Institute for

Supply Management manufacturing survey, which showed a sharp

spike in inflation expectations in February, with suppliers

citing tariffs numerous times.

"Bunds are in catch-up mode with the bid in USTs experienced

post close on Monday but with the added spin that they are bull

flattening," RaboBank rates strategists said in a note,

referring to the larger fall in shorter-dated yields than

longer-dated ones.

($1 = 0.9505 euros)