May 3, 2018 / 10:51 AM / a year ago

UPDATE 2-Euro zone bond yields sink as bloc's inflation slows unexpectedly

* Euro zone inflation unexpectedly slips in April

* German, French 10-year yields at 2-week lows

* Euro zone periphery govt bond yields (Adds quote, updates prices)

By Fanny Potkin and Dhara Ranasinghe

LONDON, May 3 (Reuters) - Euro zone government bond yields dropped across the board on Thursday after a report showed April inflation in the region slowed, a headache for the European Central Bank as it looks to unwind monetary stimulus later this year.

Inflation fell to 1.2 percent in April, according to the Eurostat flash estimate. Economists polled by Reuters had expected it to be unchanged from 1.3 percent in March.

Inflation excluding volatile food and energy prices, the ECB’s preferred measure, slowed to 1.1 percent from 1.3 percent. Excluding energy, food, alcohol and tobacco, an even narrower measure often tracked by market analysts, it eased to 0.7 percent from 1 percent.

“A considerable downside surprise to inflation is always going to have an outsize effect because so many investors are positioned for a move higher in rates,” Rabobank strategist Richard McGuire said.

The data comes after softening economic numbers and further tests the ECB’s resolve to roll back its stimulus scheme.

“It’s certainly going to make for an interesting discussion at the ECB governing council,” said Michael Hewson, chief market analyst at CMC Markets. “Rate rise expectations will be pushed back and 2019 is now very unlikely.”

The euro fell from $1.1986 to $1.1972 after the report, though it was still up 0.2 percent on the day.

French and German 10-year government bond yields fell to two-week lows after the data.

Germany’s 10-year Bund yield shed 5 basis points on the day to settle at 0.53 percent, and was set for its biggest daily fall in six weeks.

The gap over 10-year U.S. Treasury yields was 240 bps, close to the widest in almost three decades.

Southern European debt markets - considered beneficiaries of ECB largesse - outperformed, dropping 5 to 7 basis points on the inflation data .

On Wednesday, German central bank chief Jens Weidmann had said that expectations the ECB will lift interest rates towards the middle of next year remain realistic, because worries about an end of the euro zone’s economic expansion are overblown.

But after Thursday’s data, a market gauge of long-term inflation expectations in the euro zone dipped below 1.7, moving further away from a recent eight-week peak.

Money market pricing also suggests investors have tamed bets on rate hike around the middle of next year.

Eonia forward rates dated to the ECB’s meeting in June 2019 suggest an almost 80 percent chance of a 10-basis-point rate rise is priced in. Just over a week ago, expectations were more than 90 percent.

Elsewhere, Spain and France auctioned 8.49 billion euros of long-dated bonds. (Reporting by Fanny Potkin and Dhara Ranasinghe; additional reporting by Tommy Wilkes and Abhinav Ramnarayan; editing by Raissa Kasolowsky)

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