By Harry Robertson
LONDON, Dec 27 (Reuters) - Euro zone government bond yields fell to multi-month lows on Wednesday as investors returned from the holiday break and upped bets that interest rates will fall sharply next year.
Germany's 10-year yield, the benchmark for the euro zone, was down 4 basis points (bps) at 1.931%. The yield, which moves inversely to the price, fell to its lowest since March earlier in the session at 1.931%.
Italy's 10-year bond yield was last 4 bps lower at 3.507%, after falling to 3.49%, the lowest since August 2022.
"What dominates right now in the market is obviously that disinflation is underway and the fact that the market is pricing more cuts," said Emmanouil Karimalis, macro rates strategist at UBS. "This sentiment is quite bullish for bonds."
Bigger than expected drops in inflation in the U.S. and Europe, combined with a change in tone from central banks, have led markets to price in sharp falls in borrowing costs in 2024 after the rate-hiking cycle of the last two years.
Investors on Wednesday were expecting the European Central Bank to cut interest rates by around 165 bps next year, from the current record high of 4%, according to prices in derivatives markets. That was up slightly from last week and much higher than the roughly 140 bps priced in on Dec. 15.
UBS' Karimalis said the market may be getting ahead of itself in pricing a 70% chance of the first ECB rate cut in March, believing April to be more likely.
The gap between Italy's and Germany's 10-year yields was last at 155 bps, around its narrowest since June. The spread is seen as a gauge of investor confidence in the euro zone's more indebted countries.
A huge bond-market rally has boosted the riskier corners of the bond market the most, with Italy's 10-year yield on track for its biggest monthly fall since 2013, at 74 bps.
Germany's 2-year bond yield, which is sensitive to interest rate expectations, was flat at 2.415%, just above its lowest since March. (Reporting by Harry Robertson; editing by Christina Fincher)