UPDATE 3-Euro zone bond yields plunge as investors cheer ECB and Fed

(Adds analyst comment and market ECB interest rate expectations, updates prices)

Feb 2 (Reuters) - Euro zone government bond yields tumbled on Thursday after remarks from the European Central Bank and the Federal Reserve fuelled hopes that the cycle of punishing interest rate hikes might end soon.

The ECB raised rates by 50 basis points (bps), to 2.5%, on Thursday and pencilled in at least one more hike of the same magnitude next month.

“In view of the underlying inflation pressures, the Governing Council intends to raise interest rates by another 50 basis points at its next monetary policy meeting in March and it will then evaluate the subsequent path,” the ECB said.

Investors greeted the statement with glee, causing yields to crater. Yields had already fallen sharply in morning trading after the Fed lowered the pace of its rate hikes on Wednesday.

Germany’s 10-year yield was last down 21 bps to 2.086%. That was far below an 11-year high of 2.569% touched at the turn of the year. Yields fall as prices rise, and vice versa.

Italy’s 10-year government bond yield was last down 38 bps at 3.91%, putting it on track for its biggest one-day drop since March 2020.

“Markets understood from the ECB statement that after March, the central bank might pause,” said Massimiliano Maxia, a senior fixed-income specialist at Allianz Global Investors.

“It seems that the tightening cycle might end earlier than previously expected,” he added.

Despite the market’s upbeat reaction, ECB President Christine Lagarde said the central bank would “stay the course” and was committed to taming prices. Inflation fell for the third month running in January, but remained elevated at 8.5%.

The Fed said on Wednesday it had turned a critical corner in the fight against inflation after announcing an expected 25 bps hike, lower than December’s 50 bps increase, and projecting further rate increases.

The Bank of England raised rates to 4% on Thursday but signalled the tide was turning in Britain’s battle against inflation, causing investors to expect a softer approach from here.

Traders cheered the more positive tone coming from central banks, taking it as a sign that the worst of the pain might be over. Bond yields surged and prices tumbled in 2022 as central banks hiked rates hard to tame soaring inflation.

Germany’s 2-year yield, which is highly sensitive to interest rate expectations, dropped 16 bps to 2.506% on Thursday.

“Clearly, this moderation is seen as a pivot by markets,” said Florian Ielpo, head of macro at Lombard Odier Asset Management.

“Now the perception on markets is ‘50 bps more and we will have reached a plateau’,” Ielpo said, talking about the ECB. He said it was “the perfect recipe for a bonds rally”, given that investors were underexposed to bonds after 2022.

According to interest rate derivatives markets, traders now expect the ECB to hike interest rates to peak below 3.4% in late summer. They expected a peak of around 3.5% before the ECB meeting.

The closely watched spread between Italian and German 10-year yields - a gauge of the risk premium for the government bonds of Southern Europe’s highly indebted countries – tightened sharply to 180 bps. It hit its widest since Jan. 4 at 205 bps on Monday.

The U.S. 10-year Treasury yield was last down 2 bps at 3.39%, after falling 13 bps on Wednesday following the Fed meeting.

Reporting by Stefano Rebaudo; Editing by Mark Potter, Kirsten Donovan and Alex Richardson