UPDATE 1-Euro zone bonds edge down as market awaits second U.S. rate cut of year

Dhara Ranasinghe


* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates, recasts with bond yield)

LONDON, Sept 18 (Reuters) - Euro zone bond yields dipped on Wednesday before a Federal Reserve meeting that is expected to deliver the second U.S. interest rate cut of the year.

Spain's bond market largely brushed off news that the country will hold its fourth election in four years on Nov. 10, after rival parties failed to break a months-long impasse in a deeply fragmented parliament.

In a subdued session ahead of the Fed meeting, benchmark 10-year bond yields fell 2-3 basis points. Germany's 10-year bond yield dipped to -0.49%, holding below last week's six-week high of -0.43%.

After last week's ECB rate cut and stimulus package, the Fed is widely expected to lower its target rate by 25 basis points, to between 1.75% and 2.00%.

A divided Fed is facing pressure from the White House for steep interest rate cuts and an unexpected jump in overnight borrowing costs.

"Everyone knows a rate cut is expected, but we'll be looking at the statement and the dot plot," said Pooja Kumra, European rates strategist at TD Securities in London, referring to where policymakers expect rates to be in the future.

"There will also be a lot of focus on what the Fed says about the short-term funding squeeze."

The cost for banks and Wall Street dealers to borrow dollars in the overnight repurchase agreement market rose as high as 10% on Tuesday. It fell after the New York Federal Reserve said it would conduct a repurchase operation to lower the funding costs.

Analysts said the fall in yields could be related to some speculation that the Fed could expand its balance sheet again soon to help ease a short-term funding squeeze.

"The whole money market event in the U.S. has caused bit of a bid in bonds," said Lyn Graham-Taylor, fixed income strategist at Rabobank. "People may see this as the Fed having to expand its balance sheet sooner than anticipated."

Spanish yields were 2.5 bps lower at 0.27%, after news that new elections will be held.

The country has been in political limbo since Socialists emerged as the biggest party in April's parliamentary elections but without enough seats to govern on their own.

Analysts said the prospect of a new round of ECB asset purchases, unveiled last week, offset the political uncertainty.

Elsewhere, Germany sold 948 billion euros worth of 30-year government bonds against a targetted 1.5 billion euros in another weak sale of its longest-dated bonds.

"The auction was technically uncovered," said DZ bank strategist Andy Cossor. "They got more than last time but it was not a strong result." (Reporting by Dhara Ranasinghe; Editing by Larry King & Kim Coghill)