January 31, 2019 / 8:34 AM / 6 months ago

UPDATE 3-Italy recession keeps euro zone bond wagon rolling on

* Euro zone economic growth stays at lowest in four years

* Italy officially goes into recession

* German, French yields drop

* U.S. rate hike cycle might be over

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates market action, adds late move in USTs)

By Abhinav Ramnarayan

LONDON, Jan 31 (Reuters) - German and French borrowing costs dropped to new lows on Thursday as soft euro zone economic data — including news that Italy had slipped into recession — strengthened the case for owning government bonds.

Euro zone economic growth continued to rumble along at its lowest level in four years in the fourth quarter of 2018 while Italy posted a second consecutive quarterly contraction, falling short even of gloomy projections, data showed.

That raised expectations among investors that central banks will keep policy looser in response to a slowing global economy and sent euro zone government bond yields tumbling to new lows.

That view was given further credence overnight by the U.S. Federal Reserve, which discarded its promises of “further gradual increases” in interest rates, and said it would be “patient” before making any further moves.

“Hopes of a swift bounce back after the poor third quarter had already faded towards the end of the year, but the 0.2 percent growth in GDP remains disappointing nevertheless,” Bert Colijn, senior economist at ING, said of euro zone growth.

He said the European Central Bank’s staff projection of 1.7 percent growth for 2019 would probably be downgraded in March.

“With this, the almost philosophical debate in the (ECB)Governing Council of where we are and where we are going may take a more pessimistic turn that will please the doves,” said Colijn.

Germany’s 10-year bond yield fell to a four-week low of 0.152 percent, while France’s 10-year bond yield dropped to its lowest in over two years at 0.56 percent .

Most euro zone bond yields fell 3-4 bps, extending their decline in afternoon trade as U.S. yields tumbled after a measure of U.S. wage inflation came in weaker than expected.

The U.S. Federal Reserve signalled its three-year drive to tighten monetary policy might be at an end as the outlook darkens for the world’s largest economy.

“They are signalling that the rate cycle may have already come to an end, and that they are getting flexible on the next rates response,” said Commerzbank rates strategist Rainer Guntermann.

“That was the most surprising element — the balance sheet element was already flagged,” he added, referring to comments that the Fed’s balance sheet would remain larger than previously expected.

Large Spanish and Italian bond redemptions due this week had pushed South European bond yields down 3-4 bps but the news of Italy’s recession curbed some of the demand for its bonds in particular.

Italian 10-year yields were last down only about a basis point, coming off the six-month low of 2.566 percent hit in early European trade. Italian two-year yields briefly touched 0.243 percent, their lowest level since May. (Reporting by Abhinav Ramnarayan; Editing by Catherine Evans)

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