* Better-than-expected PMIs send yields higher
* Strategists say rebound takes onus off ECB policy
* Italy outperforms after summer supply canceled
* Cash drop lifts money markets, short-term yields eyed (Updates prices into close, adds reaction to U.S. jobless claims)
By John Geddie
LONDON, July 24 (Reuters) - Euro zone bond yields rose on Thursday as investors saw better-than-expected economic data as reducing the chances for the European Central Bank to loosen monetary policy further.
Germany - the bloc's economic engine room - was set to record the fastest growth rate for three years in its services sector, preliminary data showed.
The data pointed to an upturn in the health of the euro zone economy, which has been propped up in recent months by ultra-easy ECB policy that has in turn pinned government borrowing costs at record lows.
Strategists said that, without signs of recovery, markets had expected the ECB to start printing money via a programme of asset purchases referred to in economic jargon as quantitative easing - a prospect that has now diminished.
"The data came against the trend," said Piet Lammens, a strategist at KBC. "The market had discounted too much a situation where there is no quantitative easing, so you would expect yields to go higher."
German 10-year yields rose 3 bps to 1.18 percent, with most other euro zone yields climbing as well.
U.S. data showing jobless claims at their lowest in more than eight years also helped push yields higher.
Italian yields were flat at 2.74 percent, with the bonds outperforming their peers after the treasury said it cancelled scheduled bond auctions in mid-August.
MONEY MARKET PRESSURE
Euro zone money market rates edged higher on Thursday and were expected to rise further in coming days, potentially driving up short-term government bond yields, after a drop in excess cash in the bloc's banking system.
The euro overnight interbank lending rate moved back up to the top end of its recent trading range on Wednesday, analysts said, while forward rates imply it will almost double by the European Central Bank meeting in September.
"The market is pricing in this scenario we have been expecting all along - one with downside risks to liquidity and upside risks to rates for most of this summer," said Christoph Rieger, a strategist at Commerzbank.
The spare cash in the euro zone banking system dropped to 104 billion euros on Thursday, its lowest in over a month, after a bumper 21 billion euros of long-term loan repayments by banks on Wednesday.
"This will have an upwards pressure on Eonia. From currently around about 5 (basis points), I could see it move up to 8, maybe 9," said RBC's head of European rates strategy Peter Schaffrik.
A push higher in money market rates should also see short-dated bond yields rise more than those on longer-term bonds, strategists said.
Commerzbank's Rieger said German bond futures already show this trend with two-year Schatz futures close to their lowest in a month.
Strategists predict this trend will continue during the northern summer months, but that the liquidity squeeze is likely to ease in September when the European Central Bank offers its first round of targeted long-term loans to banks. (Editing by Nigel Stephenson and Gareth Jones)