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Euro zone bond yields fall as Fed debates July rate cut

Dhara Ranasinghe

* EZ bond yields down 2 to 4 bps in early trade

* Fed overnight comments in focus

* Italian BTPs continue outperformance

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr

LONDON, July 17 (Reuters) - The euro area's government bond yields tumbled on Wednesday after comments by U.S. Federal Reserve officials reinforced expectations they would cut interest rates this month and suggested they are debating how deep that cut should be.

Chicago Federal Reserve President Charles Evans said on Tuesday that an interest rate cut of half a percentage point this month could assure the Fed meets its inflation goal sooner.

Dallas Fed President Robert Kaplan, until recently a sceptic that rates should be cut at all, said he now thinks a "tactical" reduction of a quarter point could address the risks apparently seen by bond investors, who have pushed some long-term yields below shorter-term ones.

The comments set the tone for the start of bond trading in Europe, with 10-year bond yields in the euro zone falling 2 to 4 basis points.

Germany's 10-year bond was down 2.5 bps at minus 0.31% and heading back towards the record lows reached earlier this month at around minus 0.41%.

"It is very likely that we will get a rate cut in July and now the discussion is about whether we get a 25 or 50 bps cut," said Daniel Lenz, a rates strategist at DZ Bank.

Fed Chair Jerome Powell on Tuesday reiterated a pledge to "act as appropriate" to keep the U.S. economy humming, validating expectations that a rate cut is on the way.

Heightened expectations for U.S. monetary easing have fuelled expectations for the European Central Bank will cut rates in September to boost inflation and protect the economy from a global trade war.

The ECB's Benoit Coeure said on Wednesday that incoming economic data and survey information pointed to weaker economic growth in the second and third quarters.

The ECB meets next week and is widely expected to flag fresh easing measures just seven months after ending quantitative easing.

Speculation that the ECB could begin a new round of asset purchases, together with negative yields in higher-rated bond markets such as Germany and an easing in tensions between Italy and the EU over Rome's fiscal policies, have boosted Italian bonds this month.

Italy's 10-year bond yield is approaching its lowest since late 2016, while the Italian/German 10-year bond yield gap is at its lowest in over a year at around 185 bps .

Italian yields were lower in early trade, with five-year bond yields down 5 bps at 0.86% and two-year bond yields back into negative territory.

(Reporting by Dhara Ranasinghe, editing by Larry King)