UPDATE 2-Euro zone bond yields fall, shrugging off mixed inflation data

(Updates prices) By Harry Robertson LONDON, May 2 (Reuters) - Euro zone government bond yields fell on Tuesday, tracking moves in U.S. Treasuries, with the focus on inflation and the banking sector ahead of the European Central Bank's interest rate decision on Thursday. Bonds were unchanged after data showed that euro zone inflation ticked up to 7% year-on-year in April, from 6.9% in March. The closely watched core measure, which strips out energy and food costs, unexpectedly slipped to 5.6% from 5.7%. Yields climbed sharply early in the session but slipped back when euro zone bank lending data showed an exceptionally large drop in credit demand in the first quarter. The figures came a day after JPMorgan took over ailing U.S. lender First Republic, in the latest sign of the pressures on the banking system. Germany's 10-year yield , the benchmark for the bloc, was down 5 basis points (bps) at 2.264% on Tuesday, having risen more than 10 bps early in the session. Yields move inversely to prices. Yields in U.S. 10-year Treasuries dropped 14 bps to 3.437%, after rising 12 bps the day before, in a sign of relief about JPMorgan's takeover of First Republic and after strong economic survey data suggested the Federal Reserve might need to raise interest rates further to tame inflation. "The key point is what happened yesterday with the ISM report and the fact that potentially you have some contagion from the U.S. situation on the Euro situation," said Florian Ielpo, head of macro at Lombard Odier, referring to Monday's U.S. survey data, which showed signs of inflationary pressures.

CORE INFLATION Analysts said the euro zone lending figures and the dip in core inflation bolstered the case for a smaller 25 bp interest rate increase from the ECB on Thursday. But others said the tick up in headline inflation means 50 bps is still a possibility. "Sticky inflation data clearly stresses the need to continue hiking," said Carsten Brzeski, global head of macro at ING.

"But with last week's weaker-than-expected GDP growth report and today’s weak loan growth and loan demand data, the case for slowing down the pace and size of rate hikes has become stronger." Germany's 2-year bond yield, which is sensitive to interest rate expectations, fell 7 bps to 2.66% on Tuesday. Italy's 10-year bond yield was down 1 bps at 4.169, with the gap between German and Italian 10-year borrowing costs - a closely watched a gauge of investor sentiment towards the euro zone's more indebted countries - widening to 190 bps. According to pricing in derivatives markets, traders think there is roughly an 85% chance of a 25 bp ECB hike on Thursday, and a 15% chance of 50 bps. They see rates peaking at around 3.7% in November - expectations which have held broadly steady since last week. Data earlier in the day showed German retail sales fell 2.4% in March, a much worse reading than the 0.4% increase economists had expected. Separate survey data showed the euro zone factory downturn deepened in April. France's 10-year yield was down 3 bps at 2.86%.

Ratings agency Fitch cut the country's credit rating by one notch to AA- on Friday, saying potential political deadlock and social unrest posed risks to President Emmanuel Macron's reform agenda. (Reporting by Harry Robertson; Editing by Kirsten Donovan, Ed Osmond and Conor Humphries)