By Samuel Indyk
LONDON (Reuters) -Euro zone yields dropped on Thursday, following U.S. Treasuries, after Federal Reserve chair Jerome Powell signalled the central bank could slow its pace of policy tightening as soon as its December meeting.
Powell said the Fed was "slowing down" from the previous pace of three-quarter percentage point rate hikes that has prevailed since June, and would feel the way towards the peak interest rate needed to slow inflation to the Fed's 2% target.
Markets are now pricing in a terminal Fed funds rates of 4.92% at the May meeting next year. Before Powell's speech, markets had been pricing in a peak in interest rates at 5.05%, according to Refinitiv data.
Jefferies interest rate strategist Mohit Kumar said Powell's appearance on Wednesday was dovish compared to his last post-decision press conference.
"The market had built in expectations of a hawkish Powell, and he definitely did not deliver on the hawkish side," Kumar said.
"The dovish element was his view that the terminal rates would be 'somewhat' higher than the September projections, while the market has been viewing terminal rates as substantially higher than the September dot plot of 4.4%," Kumar added.
Germany's 10-year yield, the benchmark for the euro area, dropped as much as 15 basis points (bps) to 1.795%, the lowest since early October.
The two-year yield, which is more sensitive to changes in interest rate expectations, briefly fell below 2% for the first time in three weeks, dropping as much as 12 bps.
"The market is desperate to price a pivot and move on to the next story," said Rabobank rates strategist Lyn Graham-Taylor, adding that there was little new information in Powell's speech.
"Overall it was an oversized reaction," Graham-Taylor added.
The market reaction also saw a key market gauge of long-term euro zone inflation expectations rise to the highest since May at over 2.40%.
Yields also saw downward pressure on Thursday as an indicator tracked by the Fed showed signs of inflation moderating.
In Europe, Wednesday data showed inflation eased by more than expected in November, supporting the case for a slower pace of tightening from the European Central Bank (ECB) next month.
ECB chief economist Philip Lane is scheduled to speak later on Thursday, which could provide further clues on the central bank's thinking ahead of its Dec. 15 meeting.
"While it is widely accepted that the ECB will have to move into restrictive territory ... the latest inflation data has taken the edge off calls for more larger pre-emptive hiking," ING analysts said in a research note.
Traders have slightly trimmed their bets on a 75-bp hike from the ECB in December, with a 50-bp hike fully priced in and around a 25% chance of a third consecutive 75-bp rate rise, according to Refinitiv data.
Italy's 10-year yield fell as much as 17 to 3.679%, pushing the closely watched spread between Italian and German 10-year yields tighter by over 9 bps to 188 bps. <IT10YT=RR>
(Reporting by Samuel Indyk, additional reporting by Yoruk BahceliEditing by Mark Potter, Kirsten Donovan and Andrew Heavens)