Aug 24 (Reuters) -
Euro zone yields were slightly lower on Thursday, after hitting fresh multi-week lows earlier in the session, as investors scaled back their bets on the monetary tightening path after surveys showed an unexpectedly large decline in business activity.
Money markets price around a 40% chance of a 25 basis points (bps) rate hike by the European Central Bank in September, from about 60% before the bloc's purchasing managers' indexes were released on Wednesday, and a terminal rate at approximately 3.9% by year-end.
Flash PMIs showed that activity declined for the first time this year in the bloc's dominant services industry while it approached the stagnation point in the U.S.
Germany's 10-year yield dropped 1.5 bps to 2.50% after hitting a fresh 2-week low at 2.448%.
The policy sensitive 2-year yield was flat after falling to 2.92%, its lowest level since June 7.
Analysts have mixed views about the ECB's next moves, with some seeing the deposit facility rate peaking at 4% or above.
BNY Mellon Financial Economist Sebastian Vismara said that the central bank raising its deposit rate to 4.25% "remains a possibility given the ECB's renewed focus on unit labour costs."
The ECB depo rate is currently at 3.75%.
"The ECB's decision to hike or not in September now crucially hinges on next week's inflation data," said Gabriela Silova, economist at Morgan Stanley.
"The path to a hike in September has clearly become much more narrow and likely requires another upward surprise in euro area inflation next week," she added.
A Reuters poll conducted before the release of PMI data showed a narrow majority of analysts expected the ECB to pause in September while a further rate rise by year-end was still on the cards with inflation running hot.
Analysts also flagged that the September 2023 ECB euro short-term rate forward (ESTR), a key gauge of market expectations for policy rates, fell by a modest 4 bps to around 3.75% after the bloc's PMIs on Wednesday.
In August it fluctuated between 3.75% and 3.8%, implying respectively a 40% and a 60% chance of 25 a bps hike next month.
Investors are focussing on Federal Reserve Chair Jerome Powell's speech at the Jackson Hole central bankers gathering, that will be the directional catalyst of the fixed-income market, along with next week's euro area inflation data.
Powell will speak at 1405 GMT on Friday; ECB president Christine Lagarde will speak the same day at 1900 GMT.
"The general sentiment appears to be for him (Powell) to stick to the recent Fed script, if anything, with a slightly hawkish risk of more pushback against the pricing of rate cuts," ING analysts said in a note to clients.
The German yield curve deepened its inversion with the gap between 2-year and 10-year yields at -46.9, after hitting -48.7 bps its lowest level since August 11.
An inverted curve is usually a reliable indicator of a future recession and means markets are pricing events that would trigger central bank rate cuts.
Italy's 10-year yield, the benchmark of euro area periphery, hit 4.094%, its lowest since August 1.
(Reporting by Stefano Rebaudo; Editing by Toby Chopra)
