* Euro zone bond yields plunge as inflation falls to 0.7 pct
* Emerging market tension may add to deflationary pressure
* Markets expect the ECB to potentially ease policy further
* Some banks see an ECB rate cut as soon as next week
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Jan 31 Euro zone bond yields and money market rates slid on Friday after an unexpected drop in inflation intensified speculation the European Central Bank may ease its policy in coming months.
Spanish 10-year yields fell close to the eight-year lows hit earlier this month, while equivalent German, Italian, Belgian, Austrian, Finnish, and Dutch yields hit their lowest in six to seven months.
Inflation in the euro zone fell to 0.7 percent in January from 0.8 percent the previous month and compared with a forecast of 0.9 percent in a Reuters poll. The figure is well below the ECB's target of nearly 2 percent.
"This obviously raises the stakes for the ECB," said Ciaran O'Hagan, rate strategist at Societe Generale in Paris.
"Last time around (ECB President) Mr Draghi said the low inflation reading was an aberration to be corrected but it's getting harder and harder to explain."
Money market rates suggest investors expect the ECB to hold fire at its meeting next week: forward overnight bank-to-bank euro lending rates dated for the February meeting, at 0.18 percent, are higher than the spot Eonia rate of 0.155 percent.
The downward trajectory of money market rates maturing beyond February, however, indicates expectations the ECB may ease its policy later this year. The biggest declines - up to 5 bps on the day - were seen in Eonia rates from May to November - all trading at or around their lowest since mid-2013.
"The market is clearly expecting something from the ECB either a rate cut or something on the liquidity side," said Jean-Francois Robin, head of rates strategy at Natixis. "That might be the big danger here if the ECB does nothing maybe market reaction might be a bit violent in this regard.
Some banks - such as RBS and Deutsche Bank - predict prompt action from the central bank. RBS economist Richard Barwell forecast a cut in the main refinancing rate to 0.10 percent from 0.25 percent next Thursday, with the rate the ECB pays banks for holding their cash overnight remaining at zero. Deutsche economists see a 5-10 basis point cut in the three key rates, including the marginal lending rate.
Benchmark 10-year Bund yields dropped 5 bps to 1.565 percent, a six-month low.
Of particular worry is that the outlook for inflation may worsen if the sell-off in emerging markets continues.
There are several channels through which this could happen: tumbling currencies in the developing world could lead to cheaper imports, a slowdown in demand from emerging markets could push some euro zone prices lower, while investment flows into the euro zone could strengthen the single currency.
This could partly explain why Spanish and Italian bonds have shown resilience this week even during the most intense bouts of selling in emerging markets, having in past years shown vulnerability to shifts in global risk appetite.
"The EM (emerging market) developments are ... good news for the euro zone periphery," rate strategist Christoph Rieger wrote in a Commerzbank weekly note.
"Near-term uncertainty could lead to flows out of EM into euro zone countries ... Moreover, the likely slowdown of demand from some EM ... further weighs on inflation expectations, which should spur speculations about the ECB response."
Spanish 10-year yields were last 4 bps down on the day at 3.67 percent, having fallen as low as 3.653 percent, within a whisker of an eight-year low hit earlier in January. All euro zone yields fell by up to 8 bps, apart from those of Greece - whose debt markets are heavily influenced by investors exposed mainly to emerging markets - which were flat.
Analysts said the fact that peripheral yields fell after the lower inflation data could be a sign that investors still saw a very reduced risk of deflation in the euro zone.
Deflation could have a negative impact on peripheral debt markets, as it would increase their debt burden in real terms and would hurt their economic growth prospects.
"Diminishing price pressures are a double-edged sword for the periphery," Rabobank senior rate strategist Richard McGuire said. "We would argue that disinflation is positive for the periphery - higher odds of ECB stimulus - but deflation is negative - increasingly onerous debt burdens in real terms."