* German 10-year yield at one-week low after US payroll data
* Greece’s 10-year government bond yields reach 3.77 pct
* Country expected to exit bailout in August
* Euro zone yields lower on inflation data (Updates prices)
By Abhinav Ramnarayan
LONDON, Jan 5 (Reuters) - Greece’s 10-year borrowing costs dropped to their lowest in 12 years on Friday, benefiting from expectations it will exit its bailout this year, underpinned by risk appetite and a tentative economic recovery.
Greece and its creditors in the euro zone reached a preliminary agreement last month that paves the way for the country to exit the latest rescue package - its third since 2010 - in August.
That would cap a slowly strengthening recovery eight years, after Greece came close to defaulting on its debt and risked being kicked out of the single currency bloc.
Last year, the country returned to bond markets, raising hopes that it can again become financially independent.
“Greece’s fundamentals have been on the mend and investors have been looking at the yield pick-up they get from investing in that debt,” said DZ Bank strategist Christian Lenk.
“Also, a rising tide lifts all boats - with the euro zone economy doing so well, it’s a very ‘risk on’ environment and that is benefiting Greece.”
Greek manufacturing activity kept expanding in December as new orders grew at the fastest pace in over nine years, leading companies to increase hiring and production, a survey showed on Tuesday.
Having been among the best performing government bond assets in the euro zone in 2017, the yield on 10-year Greek government bonds dropped to its lowest level since February 2006 at 3.77 percent on Friday.
Short-dated Greek debt yields were also at multi-year lows: the country’s two-year borrowing costs fell to 1.47 percent and is now lower than the equivalent U.S. Treasury yield.
But despite that vote of confidence, engineering a clean bailout break remains a challenge.
“The fact that EU creditors still hold over 80 percent of (Greek) debt will mean that they insist on continued austerity and reforms,” said Jennifer McKeown, an chief European economist at Capital Economics.
“These conditions will be very difficult for Greece to meet as the electorate struggles with high unemployment ... perhaps leading to a replay of the 2015 referendum (on bailout conditions).”
A messy default and euro zone exit still could not be ruled out, she said.
Most other euro zone government bonds yields were flat to lower, after data on Friday showed that euro zone inflation was 1.4 percent in December, well below the European Central Bank’s target of just below 2 percent.
Debt yields in southern Europe — considered more dependent on ECB largesse - dropped 2 to 3 bps .
The yield on Germany’s 10-year government bond , the benchmark for the euro zone, hit a one-week low of 0.42 percent after data showed U.S. job growth slowed more than expected in December. It inched back to 0.44 percent in late trades.
Reporting by Abhinav Ramnarayan & Fanny Potkin; editing by John Stonestreet/Keith Weir