* Euro zone bond yields fall sharply after weak PMIs
* Data confirms German manufacturing sector in recession
* Expectations of ECB policy action rise
* German govt bond yields near all-time low of -0.409% (Adds details, latest prices)
By Virginia Furness
LONDON, July 24 (Reuters) - Core euro zone government bond yields slid towards all-time lows after data showed that a recession in German manufacturing had worsened, prompting investors to increase bets on a more dovish European Central Bank on Thursday.
The performance of German goods producers dropped to its lowest in seven years, a survey showed on Wednesday, adding to a grim outlook for the euro zone’s largest economy after the International Monetary Fund trimmed its estimate for German growth this year by 0.1%.
Across the euro zone, business growth has been much weaker than expected this month.
IHS Markit’s Flash Composite Purchasing Managers’ Index (PMI), considered a good guide to economic health, missed forecasts. The index dropped to 51.5 this month from a final June reading of 52.2, missing the median expectation in a Reuters poll for 52.1.
The weaker data could prompt a more dovish than expected response by the ECB at its July meeting, suggesting that rather than just changing forward guidance, policy action could be taken.
Money markets are now pricing in around a 53% chance of a 10-basis-point rate cut by the ECB at that meeting, while a 10 bps cut is fully priced in for September’s meeting.
“If we don’t see a cut, what we are going to see is some really powerful rhetoric that makes it clear that the ECB can fix the deposit problem by tiering,” said Mizuho head of rates strategy Peter Chatwell.
“The rally is led by BTPs [Italian government bonds], which tells us a good amount of quantitative easing expectations are building up, while the German two year going below minus 80bps shows expectations of rate cuts ramping up,” he said.
German 10-year bond yields fell as much as three basis points to a low of -0.39%, near the record low of 0.409% reached earlier this month, while its two-year government bond yield fell to -0.802%.
The 20-year German bond yield fell into negative territory again. It was last yielding below zero on July 5.
The figures may also feed into the U.S. Federal Reserve’s growth outlook, ahead of its meeting next week, according to Mohammed Kazmi, portfolio manager at UBP.
“The data also increases our conviction that the Fed will communicate a dovish message next week, given that the Fed itself is currently more focused on global growth data rather than domestic, and as such today’s PMIs will confirm their fears of a global growth slowdown and force them into action,” Kazmi said.
Spanish and Italian 10-year government bonds outperformed after the data, despite political uncertainty in both countries.
Spanish 10-year bond yields were last down 7 basis points to 0.329% before recovering somewhat towards the end of the European trading session.
Italian debt of the same maturity fell as much as 13 basis points to 1.469%, a new 33-month low.
Italy’s five-year bond yields were more than 10 basis points lower at 0.728%, their lowest since May 2018.
Adding to the nervousness among investors, market expectations of a no-deal Brexit rose after Boris Johnson was elected leader of Britain’s governing Conservative Party.
Johnson, who took over as prime minister on Wednesday, says he will lead Britain out of the European Union on Oct. 31 with or without a transition deal.
Reporting by Virginia Furness Additional reporting by Tommy Wilkes Editing by Mark Heinrich and Kirsten Donovan