Euro zone yields hit multi-week lows, German curve deepens inversion

By Stefano Rebaudo

Aug 24 (Reuters) - Euro zone government bond yields edged lower on Thursday after falling sharply the day before as investors adjusted their bets on the monetary tightening path after surveys showed business activity declined far more than expected in August.

Flash purchasing managers' indexes (PMI) showed that activity in the bloc's dominant services industry declined for the first time this year and approached the stagnation point in the U.S.

Money markets now price around a 40% chance of a European Central Bank rate hike in September, from about 60% before the bloc's PMIs, and a terminal rate at approximately 3.9% by year-end.

Germany's 10-year yield dropped 5 basis points (bps) to 2.47% after hitting a fresh 2-week low at 2.448%.

The policy sensitive 2-year yield hit 2.92%, its lowest level since June 7.

Analysts have mixed views about the ECB's next moves, with some seeing the deposit facility rate peaking at 4% or above.

BNY Mellon Financial Economist Sebastian Vismara said that the central bank raising its deposit rate to 4.25% "remains a possibility given the European Central Bank's renewed focus on unit labour costs."

A Reuters poll conducted before the release of PMI data showed a narrow majority of analysts expected the ECB to pause in September while a further rate rise by year-end was still on the cards with inflation running hot.

J.P. Morgan said on Wednesday, after the release of PMI data, that it forecasts the central bank to hike in October instead of September.

Deutsche Bank recalled that an ECB pause in September doesn't mean rates have peaked.

Analysts also flagged that ECB euro short-term rate forwards (ESTR), a key gauge of market expectations for policy rates, fell just 5 bps after the PMIs as Federal Reserve Chair Jerome Powell's speech at the Jackson Hole central bankers gathering will be the next directional catalyst of the fixed-income market.

Powell will speak on the economic outlook at 1405 GMT on Friday; ECB president Christine Lagarde speaks the same day at 1900 GMT.

"The general sentiment appears to be for him (Powell) to stick to the recent Fed script, if anything, with a slightly hawkish risk of more pushback against the pricing of rate cuts," ING analysts said in a note to clients.

The German yield curve deepened its inversion with the gap between 2-year and 10-year yields at -46.9, its lowest level since August 11.

An inverted curve is usually a reliable indicator of a future recession and means markets are pricing events that would trigger central bank rate cuts.

Weak data support expectations that the economy and inflation will keep slowing, and the ECB will have to cut rates.

Italy's 10-year yield, the benchmark of euro area periphery, hit 4.094%, its lowest since August 1. (Reporting by Stefano Rebaudo; Editing by Toby Chopra)