* Euro zone inflation edges down to 0.3 percent in August
* ECB sources see action only after sharp inflation drop
* Euro zone overnight bank-to-bank Eonia rates turn negative
By John Geddie and Marius Zaharia
LONDON, Aug 29 German Bund yields edged up from record lows on Friday as investors pared back expectations that the European Central Bank could ease monetary policy next week after euro zone inflation data came out only a touch lower.
ECB President Mario Draghi sent bond yields across the euro zone sharply lower at the start of the week after he highlighted a significant drop in inflation expectations in a speech at a conference of central bankers in Jackson Hole, Wyoming.
His comments spurred investors to attach a higher probability of the ECB eventually deploying a large scale asset purchase programme, known as quantitative easing, or QE. Some in the market got even bolder to bet on rate cuts and strong hints of an imminent QE programme as early as next week.
But ECB sources told Reuters the central bank was unlikely to take new action in September unless the euro zone sank significantly towards deflation.
And data showed euro zone inflation in August dipped only marginally to 0.3 percent, matching analyst forecasts.
"I got the impression from that (Reuters) article that it will take more than inflation at 0.3 percent to push the ECB into action next week," said Alan McQuaid, chief economist at Merrion Stockbrokers.
"But if you ask me whether we move to 0.50 percent or to 1.30 percent, I think it's more likely to move to 0.50 percent given the uncertainty over the euro zone economy even if nothing happens next week. The QE debate is not going to go away."
German 10-year Bund yields, the benchmark for euro zone borrowing costs, rose 1 basis point to 0.89 percent, having hit a record low of 0.86 percent on Thursday. link.reuters.com/fug72w
Strategists said that any further rise in yields was likely to be capped by tensions between Russia and the West over the conflict in Ukraine - a dispute which has seen investors cling to top-rated assets.
Kiev accused Russian troops on Thursday of illegally entering eastern Ukraine and, backed by its U.S. and European allies, has said it will fight to defend its soil.
Russian Foreign Minister Sergei Lavrov said on Friday allegations that Russia's military is fighting in eastern Ukraine were "conjecture".
Spanish and Italian 10-year yields were flat at 2.24 and 2.45 percent, remaining near their record lows.
The steady push lower in core yields has also contributed to an anomaly emerging in money markets where banks are paying to lend to their peers on an overnight basis.
The euro overnight bank-to-bank lending rate fixed below zero for the first time on Thursday, a move that shows the problems top-tier banks face in managing excesses of overnight liquidity.
Transacting with other banks at negative rates is less costly than depositing at the ECB or investing in short-term, liquid financial assets such as German bonds which return negative yields in maturities out to four years.
"Some banks have just realised that without alternatives, you just have to take the hit and transact at negative rates," said Commerzbank money markets strategist Benjamin Schroeder. (Editing by Mark Heinrich)