Cooler-than-expected US CPI sends euro zone yields to 2-month low

(Updates at 1600 GMT)

By Stefano Rebaudo and Samuel Indyk

Nov 14 (Reuters) - Yields on euro zone government bonds and U.S. Treasuries fell on Tuesday after cooler-than-forecast U.S. inflation data cemented expectations that the Federal Reserve was probably finished with rate hikes.

In the 12 months through October, the U.S. consumer price index rose 3.2%, down from 3.7% in September and below the forecast from a Reuters poll of economists of 3.3%. The core CPI rose 4% on an annual basis in October, down from September's 4.1%.

"This should reaffirm the Fed's view that interest rates are restrictive enough to bring inflation back to target," said Richard Garland, chief investment strategist at Omnis Investments.

"Although a comforting inflation reading is still some distance away, the labour market is weakening and economic growth is set to slow as consumers reign in their spending; a soft landing for the economy still looks most likely."

Euro zone bond yields tracked U.S. counterparts, with Germany's 10-year government bond yield, the benchmark for the bloc, 11 basis points (bps) lower at 2.605%, its lowest level since Sept. 15.

The benchmark 10-year U.S. Treasury yield fell 17 bps after the data to 4.4628%, its biggest one-day fall since worries about the global financial escalated with the collapse of SVB Financial in March.

Traders, meanwhile, erased any expectations that the Fed would raise rates further and added to bets that rate cuts could begin in the first half of next year.

Markets now price in around a 60% chance that the Fed will cut interest rates by May next year, according to the CME's FedWatch tool, up from around a 34% chance the day before.

Markets are also betting that the European Central Bank is finished with rate hikes and see cuts in early 2024.

April 2024 ESTR forwards were at 3.712%, implying around a 75% chance that the ECB will cut its deposit rate from 4% at its April meeting next year.

ECB officials, however, have tried to push back on market expectations for rate cuts.

ECB President Christine Lagarde, when asked how long rates would have to stay at high levels to win the battle against inflation, said in an interview during the weekend that no change should be expected in the "next couple of quarters".

Economists expect the ECB to hold interest rates steady well into next year, with most polled by Reuters sticking to forecasts that the first cut will have to wait until at least July despite expectations of a euro zone recession.

Italy's 10-year government bond yield, the benchmark for the euro area's periphery, was down 14.5 bps at 4.42%, its lowest level in two months.

The gap between Italian and German 10-year yields - a gauge of the risk premium investors ask to hold bonds of the euro zone's most indebted countries - was 180 bps.

On Friday Fitch kept Italy's 'BBB' credit rating unchanged, with a stable outlook.

Moody's - which rates Italy one notch below Fitch and S&P, and one notch above the investment grade level with a negative outlook – will update its assessment on Friday. Still, most analysts do not expect Italy to lose its investment grade rating in the absence of a domestic political shock.

(Reporting by Samuel Indyk and Stefano Rebaudo; Editing by Mark Potter, Barbara Lewis, Christina Fincher and Jonathan Oatis)