LONDON, Dec 14 (Reuters) - Euro zone bond yields edged up on Wednesday, as investors cashed in on a rally the day before following U.S. inflation data that fuelled investor expectations for the Federal Reserve to signal it may raise rates more slowly.
The Fed releases its decision on interest rates later on Wednesday. The central bank is expected to increase the federal funds rate by 50 basis points to a range of 4.25-4.50%.
Data on Tuesday showed consumer inflation rose by just 7.1% in November, slowing for a fifth straight month, along with a decline in the core rate, which excludes food and energy prices.
The Fed is one of a number of major central banks, including the Bank of England and the European Central Bank, that releases its final monetary policy decision of the year this week.
Investors expect to see central banks deliver smaller rate hikes for the first time in months, as inflation is showing signs of having peaked and, as a result, the U.S. dollar has retreated. The greenback has shed 10% in value since hitting two-decade highs in October.
"Markets will look for the relative degree to which the central banks signal that they are ready to declare at least a pause in the hiking cycle soon," strategists at Saxo Bank said in a note.
"With the late dollar weakness, a dovish shift is more likely," they added.
German 10-year yields, which fell by as much as 8 basis points after the U.S. inflation figures, were last flat on the day at 1.908%.
The ECB is grappling with double-digit inflation across the euro zone that is hammering the economy. It's expected to raise interest rates by half a point to 2.00%, which would bring total increases this year to a cumulative record 250 basis points.
But this has done little to reassure investors that headline inflation is going to come down any time soon. A key market-based gauge of long-term inflation expectations for the euro zone has steadily risen to around 2.4% from closer to 1.8% at the start of the year, largely because of the surge in energy prices in the region since Russia's invasion of Ukraine squeezed natural gas supply.
Euro zone inflation eased more than expected in November, but underlying price growth is still stubbornly high. Similarly, data on Wednesday showed UK inflation has eased from 41-year peaks, but much of this was driven by a decline in the cost of motor fuels.
"We don't know if the peak in the headline is behind us or ahead of us and, there have been downward surprises in the UK this morning and in the euro zone in November due to energy prices. Energy prices have gone down, but they may well go back up," ING senior rates strategist Antoine Bouvet said.
The ECB's benchmark rate is expected to peak around 2.8% by next July according to interest-rate futures.
The performance among peripheral bonds was very much in line with that of Germany. Spanish bond yields rose 1 bp to 2.987% following data that showed inflation slowed to 6.7% in November, the smallest annual increase this year and the fourth straight increase.
Italian 10-year yields were the laggards, rising 9 bps to 3.866%. But they've been one of the major beneficiaries of the recent strength in the euro and the expectation for a more measured set of rate rises from the ECB.
Italian yields have fallen by 64 bps in the fourth quarter, compared with a decline of 31 bps in Spanish yields and just 15 bps in German yields. (Editing by David Evans)
