By Fanny Potkin
LONDON (Reuters) - Euro zone bond yields fell sharply on Thursday as weaker than forecast business activity data, fears of a trade war and signs that the U.S. interest rates will not rise as much as expected this year served to renew demand for fixed income.
Ten-year bond yields in Germany and Italy, two of the bloc's biggest bond markets, fell to two-month lows while Spanish yields hit their lowest in 16 months.
The declines began after the U.S. Federal Reserve raised interest rates on Wednesday and forecast two more increases for 2018 -- rather than the three that markets had expected -- and gathered momentum after data showed the euro zone economy losing steam.
Preliminary purchasing managers index numbers (PMIs) for March showed euro zone businesses had their slowest growth in more than a year as new business took another hit from a stubbornly strong euro.
An Ifo Institute survey showed that German business confidence dropped to its lowest level in nearly a year in March on concerns about the rising threat of protectionism.
"It's very expensive to be short on European fixed income," said Charlie Diebel, head of rates at Aviva Investors.
"People were happy to do that when the data was printing so strong. But in a world where the U.S. rate outlook is probably neutral ... and there is some lessening of the economic data, expecting people to drive a sell-off is hard to do."
Germany's 10-year Bund yield, the benchmark for the bloc, fell to a 10-week low of 0.52 percent, down 7 basis points on the day. It was set for its biggest one-day fall since December 2016.
REDUCED ISSUANCE
News that Germany will cut its debt issue plans for the second quarter by 2 billion euros because of a surge in tax revenue added to downward pressure on German yields.
German five-year yields fell to a six-week low of minus 0.057 percent at one stage, while 30-year Bund yields hit their lowest since December 2017 at 1.17 percent and were set for the biggest one-day fall in a month.
Long-term euro zone borrowing costs were down 5-8 bps across the board after the PMI data.
The bloc's economic boom had already paused in February as rising prices left a mark; worrying for a European Central Bank looking to move away from ultra-loose monetary policy.
Spain's 10-year yield hit a 16-month low of 1.285 percent, down 4 bps on the day, while Italy's 10-year bond hit a two-month low of 1.887 percent.
"To some extent the market was expecting a hawkish Fed but did not get a signal for a fourth rate hike this year," said Orlando Green, European fixed-income strategist at Credit Agricole.
He added that risk factors such as the potential threat of a global trade war were also supporting safe-haven debt markets.
U.S. President Donald Trump is expected to announce tariffs on Chinese imports later on Thursday in a move that is likely to trigger retaliation from Beijing.
A Bank of England meeting was also in focus after strong wage data on Tuesday boosted expectations for a May rate increase.
(Reporting by Fanny Potkin; Additional reporting by Dhara Ranasinghe; Editing by Keith Weir and David Goodman)
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