(Recasts, adds background)

By Harry Robertson

LONDON, July 30 (Reuters) - Germany's two-year bond

yield, which is sensitive to European Central Bank interest rate

expectations, fell to a six-month low on Tuesday on the back of

encouraging inflation data.

Figures showed Spain's inflation rate slowed by more than

expected in July, to 2.9% year-on-year from 3.6% in June.

Data from individual German states failed to trigger

significant price action in the fixed income market.

Germany's two-year bond yield fell to 2.568%, its

lowest since early February, after the Spanish data and was last

down 1.5 basis points (bps) at 2.58%.

Data also showed Germany's gross domestic product (GDP)

contracted by 0.1% in the second quarter, although economies

grew in Italy, France and Spain.

Traders slightly increased their bets on ECB rate cuts this

year to price in 54 bps of further easing from the current 3.75%

level, according to derivative market pricing. Shorter-dated

bond yields are highly sensitive to expectations around central

bank interest rates.

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

euro zone bloc, dropped 0.5 bps to 2.35%, just above a six-week

low. Yields move inversely to prices.

Inflation data for the euro zone as a whole is due for

release at 0900 GMT on Wednesday. Investors are also waiting for

interest rate decisions from the U.S. Federal Reserve and Bank

of Japan on Wednesday, and the Bank of England on Thursday.

Closely watched monthly U.S. jobs data is due on Friday.

Italy's 10-year yield also fell 1 bp to 3.70%,

and the gap between Italian and German bond yields

stood at 135 bps.