US/German bond yield gap widest in 20 years on diverging policy outlooks

* Short-dated "transatlantic spread" widest since 1997

* Powell vows to stick to rate hikes in the U.S.

* Euro zone inflation drops, underlining ECB caution

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (updates prices, adds Powell)

By Abhinav Ramnarayan

LONDON, March 1 (Reuters) - The gap (Frankfurt: 863533 - news) between short-dated borrowing costs in the United States and Germany widened on Thursday to its biggest in more than 20 years as the monetary policy outlooks for the two regions diverge.

The spread narrowed slightly by close of day after Federal Reserve chairman Jerome Powell's second testimony this week pushed U.S. Treasury yields lower, but the premium over German yields should remain in place.

Powell reiterated the views he had expressed on Tuesday that U.S. interest rates would rise gradually but he also, crucially, said there was no evidence the economy was overheating.

That pushed down 10-year U.S. yields to two-week lows while the yield curve - the gap between the 5- and 30-year yields - steepened, having flattened after Powell's upbeat assessment on Tuesday..

However, with the United States close to full employment, bets are likely to remain in place that President Donald Trump's massive infrastructure spending programme will force the Fed to tighten monetary policy more than planned.

In the euro zone on the other hand, slowing inflation will stymie the European Central Bank's plan to remove stimulus, many reckon.

The U.S./Germany two-year bond yield spread widened to 281 basis points, the largest gap since April 1997 , though it slipped back to around 279 bps by 1700 GMT.

The 10-year "transatlantic spread" was at 221 bps, close to its widest in over a year.

"In the U.S. we have at least three rate hikes this year, but in the euro zone, there was some exaggeration about where the inflation was heading so that is now being priced out and yields are moving to the downside," said DZ Bank strategist Daniel Lenz.

Latest data has shown euro zone consumer prices rising just 1.2 percent in February, well below the central bank's target of just below 2 percent.

In addition, a survey on Thursday showed the euro zone's factory boom slowed further last month, pressuring euro zone yields lower even though the bloc is still enjoying its best growth spell in almost two decades.

Overall, high-grade euro zone bond yields dropped after IHS Markit (NasdaqGS: MRKT - news) 's final manufacturing Purchasing Managers' Index for the euro zone fell to 58.6 in February from 59.6.

Germany's 10-year government bond yield, the benchmark for the region, dropped to a one-month low of 0.62 percent, down 3 bps on the day, pushed lower by the release but edged up later to 0.64 percent.

Two-year Bund yields slipped to two-week lows.

"We have had an acceleration phase in the economic cycle in Europe and now we're in a more mature growth phase so the period of sharp bond market selloff is probably behind us in Europe. The U.S. is a different story," Mizuho strategist Antoine Bouvet (LSE: 0HDU.L - news) , said.

The ECB is due to meet next week, and many investors will be keeping an eye on how forward guidance - a tool used by policymakers to impact rate hike expectations - could be changed, said Lenz of DZ Bank.

At the moment, money market investors are pricing in a roughly 30 percent chance of a rate hike by the end of 2018.

Three sources told Reuters on Wednesday the ECB could discuss tweaking its communication stance at the March 8 meeting, but no major policy shift is expected.

(Reporting by Abhinav Ramnarayan and Sujata Rao; Editing by Dhara Ranasinghe and Alison Williams)