LONDON, July 17 (Reuters) - Euro zone yields held firm on Wednesday, heading for their largest weekly decline in a month, a day before a European Central Bank meeting that could offer a signal of where interest rates may go over the rest of this year.
The consensus among market-watchers is there will be no change to ECB monetary policy and euro zone rates will stay at 3.75%, so the focus will be on what the central bank flags about the outlook for the September meeting.
German 10-year bond yields, the benchmark for the euro zone, were unchanged at 2.425%, having touched their lowest in three weeks earlier in the day. Bunds are also heading for a decline of 7 bps this week, the largest weekly fall since mid-June.
Italian 10-year yields, meanwhile, traded 1 bp higher at 3.72%, near three-month lows, leaving their premium over German Bunds 1.5 bps wider at 128.9 bps.
Signs that inflation is slowing around the world, alongside some nervousness in European assets due to geopolitics have helped euro zone bond prices to rally, which has pushed yields lower.
The ECB meets on Thursday and is widely expected to hold interest rates steady, while the outlook for future rate cuts will depend on how the economy evolves.
Inflation has dropped since the ECB last met, but has failed to subside in the dominant services sector. Some policymakers said they felt cornered into June's rate cut and are in no hurry to flag what's next.
ECB President Christine Lagarde at the last meeting indicated policymakers would aim to loosen monetary policy gradually, which Martin Wolburg, senior economist at Generali Investments, said indicated any action on Thursday was "extremely unlikely".
He cited stubbornly high services inflation and a pickup in wage growth as reasons the ECB Governing Council will act with a caution.
"From ECB communication, we concluded that further easing measures will need to be checked with the updated macro outlook that is next due by September. We expect Mrs Lagarde to convey a dovish wait-and-see stance at tomorrow’s press conference and look for the next rate cut by September," Wolburg added.
The swaps market shows traders expect at least one more rate cut this year from the ECB, with an 80% chance of a cut in September and a reasonable chance of another reduction before the end of the year.
Against that backdrop, the German yield curve - or gap between shorter- and longer-dated bond yields - has been steadily flattening for the last three months.
Two-year yields, which are more sensitive to shifts in expectations for rates, are just 36 bps above 10-year yields, up from around 44 bps a month ago and versus 90 bps a year ago.
Two-year Schatz yields were last up 1 bps at 2.779%. (Editing by Arun Koyyur, Philippa Fletcher, Alexandra Hudson)
