May 6 (Reuters) - Euro zone government bond yields dropped on Monday in thin trade due to a Bank Holiday in London after Friday's U.S. economic data moved the needle of market bets towards a higher chance of two Federal Reserve rate cuts in 2024.
Meanwhile, the spread between Italian and German 10-year bond yields hit a 1-1/2-month low after Fitch confirmed its rating on the Italian debt.
Germany's 10-year bond yield, the benchmark for the euro zone, fell 6 basis points (bps) to 2.45%.
U.S. Treasury yields were down 2.5 bps in London trade after tumbling to multi-week lows on Friday on news that the world's largest economy created fewer jobs than expected in April.
"We see a risk that a too-dovish Fed could lead to some (yield curve) steepening from here. The back end won't feel protected enough, while the front end could start settling on a September cut," said Padhraic Garvey, regional head of research Americas at ING, mentioning a likely spillover effect on Bunds.
The German yield curve was still inverted but steepened on Friday with the gap between 10-year and 2-year German yields tightening to 43 bps after four straight widening sessions. It was at 44 bps on Monday.
Money markets price in 75 bps of ECB rate cuts in 2024 and 48 bps for the Fed, which implies one 25-bp cut and a 90% chance of an additional move.
Italy's 10-year yield dropped 7 bps to 3.75%, and the gap between Italian and German 10-year yields - a gauge of the risk premium investors ask to hold bonds of the euro area's most indebted countries - was at 128 bps after hitting 122.60 bps, its lowest since March 20.
"European government bond spreads have room to tighten amid buoyant risk sentiment and the favourable flow pattern in May," said Rainer Guntermann, economist at Commerzbank.
"Rating risks remain contained with Fitch having just affirmed Italy and the market not fretting about Moody's review at the end of May after it raised the outlook to stable in November 2023," he added. Investors will closely watch the sale of BTP-Valore, which starts on Monday, as Italian small savers will likely rush to buy the new retail bond, taking advantage of the last opportunity to lock in higher returns before the ECB starts cutting interest rates.
The case for an ECB interest rate cut in June is getting stronger as services inflation is finally starting to ease, said ECB Chief Economist Philip Lane. (Reporting by Stefano Rebaudo, editing by Emelia Sithole-Matarise)
