By Stefano Rebaudo
Sept 29 (Reuters) - Euro zone government bond yields dropped on Friday but were set to end the week with their biggest quarterly rise in a year as investors keep betting on policy rates being higher for longer.
Meanwhile, the risk premium on Italy's sovereign debt fell to 193 basis points (bps) after briefly hitting 200 bps in early London trade, as investors were already repositioned for lower growth and a higher public deficit.
They were now shifting their focus to new European Union fiscal rules, which could be approved by year-end, and risks of recession in the euro zone, analysts said.
Germany's easing inflation data failed to trigger expectations for a softer ECB stance on Thursday, with Bund yields rising more than 10 bps.
Analysts said consumer price dynamics remain elevated while oil prices keep rising. Meanwhile, data in Germany and many other European countries continues to be surrounded by more statistical noise than usual, making it harder for the ECB to take them at face value, some argued.
Oil prices slipped on Friday but were headed for a gain of 2% for the week.
Germany's 10-year government bond yield, the benchmark for the euro area, was down 10 bps at 2.87% after jumping 13.5 bps the day before.
It was set to end the week up 14 bps, in its biggest weekly rise since early July, and was heading for a 47 bps rise for the quarter - its largest since the third quarter last year, which saw yields rising by 45 bps.
ECB policymakers have kept sending hawkish messages, with Bundesbank President Joachim Nagel saying on Thursday that the ECB might need more rate hikes and that he is in favour of a quick reduction in the central bank's balance sheet.
The ECB can narrow its asset holdings by selling bonds in the market in a move that will tighten financial conditions.
Germany's 2-year yield, most sensitive to expectations for policy rates, was down 6 bps at 3.24% and was set to end the week up 1 bp.
Markets are pricing policy rates at the current levels for longer as long-dated yields keep rising.
“Duration (long-dated bonds) aversion is feeding on itself. After major levels were taken out on no major news, investors feel vindicated in their preference for cash at a time when supply prospects for next year appear to be getting more challenging," said Christoph Rieger, head of rates and credit research at Commerzbank.
A strong supply of bonds drives their prices down, raising yields.
Italy's 10-year yields, the benchmark for the euro area's periphery, were down 9 bps at 4.79% and were set to end the week up 21 bps in their biggest weekly rise since early July.
The spread between Italian and German 10-year yields – a gauge of the risk premium investors want to hold Italian government bonds – was at 192, after briefly hitting 200.1 bps. (Reporting by Stefano Rebaudo; Editing by David Holmes)