By Samuel Indyk
LONDON (Reuters) -Euro zone borrowing costs rose sharply on Monday as investors scaled back expectations of outsized interest rate hikes in the euro area and the United States, boosting sentiment and stock markets on both sides of the Atlantic.
Investors have lowered their expectations for European Central Bank rate rises this year and also now expect the U.S. Federal Reserve will raise rates later this month by 75 bps, not 100 bps.
"We've had a positive tone in terms of equities as the market looks at future policy decisions from the Fed and the ECB a little bit more constructively and priced out near-term tightening," said Richard McGuire, head of rates strategy at Rabobank.
Germany's 10-year bond yield, the benchmark for the bloc, was up about 10 basis points at 1.22%, pulling away from seven-week lows hit on Friday.
Caution ahead of Thursday's ECB meeting triggered some volatility during the session with Italy still in the spotlight.
Italy's Prime Minister Mario Draghi tendered his resignation last week after one of the parties in his broad coalition, the 5-Star Movement, refused to back the government in a parliamentary confidence vote.
President Sergio Mattarella rejected his resignation, however, and asked Draghi to address parliament this week, in the hope that he can find a consensus to stave off early elections.
Italy's 10-year bond yield rose as much as 12 basis points (bps). The yield was last up about 5 basis points at 3.41%.
The closely watched spread over German Bund yields at one stage touched its widest in over a month before settling above Friday's close at around 219 bps.
The ECB is expected to announce details of a new tool aimed at containing stress in bond markets but some analysts believe it might not yet provide an immediate game changer.
"Our concern is that what will come out on Thursday could still be too vague, or too narrow in scope, to signal to the market that the 'cavalry is coming' quickly to shore up the Italian bond market," Gilles Moëc, chief economist at AXA Investment Managers wrote in a note.
The ECB has flagged a 25 bps rate hike and money markets price in around a 35% chance of an outsized 50 bps move, down from around 40% on Friday, according to Refinitiv data.
Markets are still pricing in around 160 bps of tightening from the ECB by year-end, implying that a hike of at least 50 bps could come at one or more of the ECB's next four meetings.
(Reporting by Samuel Indyk; additional reporting by Dhara Ranasinghe and Julien Ponthus; editing by Dhara Ranasinghe, Gareth Jones, Hugh Lawson and Susan Fenton)