Jan 30 (Reuters) - Euro zone yields fell on Thursday

amid weak economic data as investors awaited a European Central

Bank policy meeting, which is widely expected to cut rates by 25

basis points and keep the door open to further policy easing.

The German economy contracted more than expected in the

final quarter of last year, spurring recession fears.

ECB President Christine Lagarde is likely to argue that the

direction of policy remained clear and that the risk of a trade

war with the United States could sap weak growth even more.

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

benchmark, fell 4.5 basis points (bps) to 2.53%.

U.S. 10-year Treasury yields dropped 5 bps to

4.51% in early London trade. They reversed an earlier rise on

Wednesday after Federal Reserve Chair Jerome Powell said he

expects to see further progress on inflation.

Money markets priced in a 95% chance of a 25 bps ECB rate

cut on Thursday and a deposit facility rate at 2.1%

at the end of 2025 from the current 3%.

Germany's two-year bond yield, more sensitive to

ECB rate expectations, was down 4.5 bps at 2.23%.

Italy's 10-year yield was 4 bps lower at 3.62%.

The gap between Italian and German yields -- a

market gauge of the risk premium investors demand to hold

Italian debt -- widened to 108 bps, but was not far from its

lowest level since October 2021 at 104.50 bps.

The Italian economy stagnated in the fourth quarter, casting

a shadow over prospects for this year.

Analysts said declining ECB policy rates would support

demand for BTPs from investors keen on locking in high returns.

Michael Leister, strategist at Commerzbank, argued that this

"ECB-euphoria" has faded, but lowering volatility should boost

appetite for carry, supporting spreads.

A carry trade is an investment strategy where investors

borrow money in a low-rate market and invest in a

higher-yielding currency or asset.

The yield spread between OATs and Bunds stood

at 74 bps as a small panel of French senators and members of

parliament will meet on Thursday to thrash out the final text of

a much delayed 2025 budget, after talks teetered on the brink of

collapse on Wednesday.

The spread widened to around 90 bps, its highest since 2012,

in mid-January and end-November amid concerns that France would

struggle to cut its growing budget deficit.

A reconciliation among political parties might still happen,

"but it does reduce this government's stability," Citi said in a

research note.

"Overall, however, we don't see this as a meaningful

development given snap elections remain likely in third quarter

and the 2025 budget is perhaps the only meaningful legislation

ahead of that."

France's economic activity retreated slightly in the fourth

quarter despite firm consumer spending as the boost from the

Paris 2024 Olympic Games waned.