European debt rally pauses at start of a big week for bond markets

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr

By Saikat Chatterjee

LONDON, July 22 (Reuters) - Core European government bond yields steadied on Monday after posting their biggest weekly drop in seven weeks as investors consolidated positions before a central bank policy meeting this week where policymakers might unveil plans of more rate cuts.

Though hopes have grown that the ECB might cut its deposit rate as soon as Thursday to soften the impact on the euro from a much-awaited Fed rate cut, market watchers say policymakers will change its forward guidance before taking fresh steps.

Money markets are assigning a 55% probability of a 10 basis points deposit rate cut with a Reuters poll expecting the ECB to change its forward guidance towards more easing this week and move to cutting interest rates only in September.

As a result, German bond yields for 10-year maturities were broadly steady at minus 31 bps in early London trading and within striking distance of a record low of minus 40 bps hit earlier this month.

Spreads between benchmark U.S. debt and corresponding German bonds were broadly steady at 273 bps.

Barclays strategists note that although hope of more ECB easing has increased since ECB President Mario Draghi's June speech in Sintra, downside risks to the eurozone economy have not increased over that period.

Moreover, the Fed is also expected to cut rates by only a quarter point, compared to some bets of a half point rate cut.

"Therefore, we do not think Draghi will want to soften his easing bias from the Sintra speech...President Draghi is very likely to prepare the ground for a broad easing package in September," they said in a weekly note.

Ongoing tensions between Britain and Iran over the seizure by Iran of an oil tanker is also set to keep demand of safe-haven core European debt intact.

Markets were also watching for political developments in after tensions rose in the ruling coalition party last week, raising concerns that the increasingly unwieldy government might collapse.

Though Italian bonds have also broadly been the beneficiary of expectations of more ECB policy stimulus, with yields on 10-year debt falling by 120 bps since mid-May, the rally has stalled since late last week.

Story continues

"We need to watch for more developments on the Italian political situation," said Daniel Lenz, a rates strategist at DZ Bank in Frankfurt.

On a technical note, primary market activity is likely to remain slow with only Belgium and to sell bonds this week though the net issuance of 4.5-6 billion euros ($11.78 billion) is expected to be more than offset by inflows from redemptions and coupon payments, according to strategists at Unicredit.

($1 = 0.8915 euros) (Reporting by Saikat Chatterjee Editing by Raissa Kasolowsky)

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