Fed chief speculation takes edge off euro zone bond market rally

By Dhara Ranasinghe

LONDON (Reuters) - Borrowing costs in the euro area inched up from one-month lows on Tuesday, as bond investors weighed up the implications of a potentially more hawkish Federal Reserve chief taking over from Janet Yellen.

U.S. short-term interest rates and bond yields jumped on Monday on news that Donald Trump met Stanford University economist John Taylor to discuss the job of Fed chair as the U.S. President seeks candidates to succeed Yellen next year.

Taylor is known as a proponent of a rule-based monetary policy and according to his formula, known as Taylor rule, the Fed funds rate needs to be much higher than the current target of 1.0 - 1.25 percent.

The policy-sensitive two-year U.S. Treasury yield on Monday jumped as high as 1.546 percent <US2YT=RR>, its highest since 2008.

But upward pressure on euro zone bond yields, which often move in line with U.S. peers, was limited as investors take a view that any unwinding in European Central Bank stimulus is likely to be prolonged to buffer the bloc's economy.

Reports at the end of last week that ECB policymakers are moving towards announcing more asset purchases at lower volumes when they meet next week have given euro zone bond markets a strong boost in the last two trading sessions.

In early Tuesday trade, German 10-year bond yields were up about one basis point on the day at 0.38 percent, off one-month lows hit a day earlier <DE10YT=TWEB>.

Other bond yields in the single currency bloc were also a touch higher, pulling back from Monday's lows.

"There is a bit of a headwind from the U.S. because Taylor is known for a rule-based approach that would imply rates being higher than they are now," said Commerzbank rates strategist Rainer Guntermann.

"But the soft-as-possible exit scenario from the ECB means that the bullish dynamic in euro zone bond markets may not be over yet."

In contrast to the ECB, the Fed's Yellen said at the weekend that the economy remained strong -- reinforcing a view of further U.S. rate rises, and putting upward pressure on Treasury yields.

That has left the gap between 10-year bond yields in Germany and the U.S. at around 193 basis points and close to its widest levels in four months.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets

(This version of the story has been refiled to fix typo in first paragraph)

(Reporting by Dhara Ranasinghe; editing by John Stonestreet)