Weak stocks, UK PMI warning lift edgy euro zone bonds

By Dhara Ranasinghe

LONDON, May 24 (Reuters) - Euro zone bond yields fell on Tuesday as sliding stock markets and news of a sharp slowdown in UK business activity offered investors a respite from the increasingly hawkish messages coming from the European Central Bank chief.

In another day of volatile trade, borrowing costs were pushed in one direction then another from conflicting forces, but the combination of poor UK data and weak equity markets held sway into the close.

Momentum in Britain's private sector slowed much more than expected this month, adding to recession worries as inflation pressures ratcheted higher, according to a business survey.

As British gilt yields tumbled, euro zone bond yields were dragged with them. The move lower accelerated in afternoon trade as the risk-off mood spilled over to U.S. debt markets.

"The weak equity backdrop was already supportive for bonds and then we had the dreadfully weak UK PMI data, which has seen UK gilt yields drop like a stone," said Richard McGuire, head of rates at Rabobank.

Germany's benchmark 10-year Bund yield was down 6.7 basis points (bps) on the day at 0.95% by 1501 GMT, having pushed above 1% earlier, as 10-year gilt yields tumbled more than 10 bps.

Italian 10-year bond yields were also 5.8 bps lower after rising to a two-week high earlier in the session after latest comments from ECB boss Christine Lagarde kept markets alert to rate hike risks.

Lagarde said on Tuesday she saw the ECB's deposit rate at zero or "slightly above" by the end of September, implying an increase of at least 50 basis points from its current level.

The comments came a day after Lagarde accelerated a policy turnaround that has seen her go from all but ruling out a move this year to pencilling in several hikes. The ECB's key depo rate is at -0.50%.

Unease that the ECB is now heading fast towards the stimulus exit given record high inflation was most felt in southern Europe markets, the biggest beneficiaries of ECB largesse in recent years.

Greece's 10-year bond yield rose to its highest level since 2020 for a third straight session, hitting 3.77% before falling in line with broader bond markets.

"The ECB is trying to convey the message of gradual rate hikes," said Nordea chief analyst Jan von Gerich. "In general the message is hawkish and she (Lagarde) has opened the door to bigger hikes further out."

Money markets are fully pricing in a 25 bps hike at the ECB's July meeting with a nearly 50% chance of a bigger move anticipated.

Euro zone business growth slowed this month, but was still relatively strong, as the cost of living crisis put a dent in consumer spending power while a shortage of raw materials held back expansion in manufacturing, the flash euro zone PMI meanwhile showed.

In a busy week for euro zone debt issuance, France's debt management office said it would launch a green, inflation-linked bond soon, while Austria launched the sale of its first ever 'green' bond.

Finland hired banks to sell a new 3 billion-euro 10-year bond, according to a lead manager memo seen by Reuters. The sale comes after Russia's Gazprom halted gas exports to Finland on Saturday. Finnish debt has underperformed other higher-rated euro zone peers this week.

(Reporting by Dhara Ranasinghe, additional reporting by Danilo Masoni and Yoruk Bahceli; Editing by Susan Fenton)