Euro area yields plunge as tariff fears boost bets on ECB rate cuts

April 7 (Reuters) - Euro area short-dated yields hit a fresh 2-1/2-year low on Monday as fears about the economic impact of U.S. tariffs triggered a rout in stocks and led investors to boost bets on future European Central Bank rate cuts.

U.S. President Donald Trump warned foreign governments they would have to pay "a lot of money" to lift sweeping tariffs, characterising the duties as "medicine".

German 2-year yield DE2YT=RR, more sensitive to expectations for European Central Bank policy rates, dropped 16.5 basis points (bps) to 1.69% after hitting 1.665%, its lowest level since early October 2022. It was on track for its biggest three-day fall since mid-March 2023.

"Markets are testing Trump's resolve, but the U.S. President is still standing firm," said Rainer Guntermann, rate strategist at Commerzbank.

Money markets priced in an ECB depo rate at 1.65% in December EURESTECBM6X7=ICAP from 1.75% on Friday and 1.9% last week shortly before Trump announced U.S. tariffs. They also discounted a 90% chance of a 25 bps cut next week.

"A tit-for-tat escalation with trading partners responding in kind to Trump and Trump then imposing new levies on countries that fight back would worsen the trade wars and exacerbate the crippling uncertainty," said Holger Schmieding, chief economist at Berenberg, recalling the trade war which culminated in the Great Depression.

"In an extreme case, the selloff in equity markets could turn into a temporary panic that would add further to uncertainty and weigh even more on spending decisions."

Major stock indexes plunged on Monday, and investors bet the mounting risk of recession could cause the Federal Reserve to cut interest rates as early as May.

Germany's 10-year yield DE10YT=RR, the euro area's benchmark, fell 10.5 bps to 2.51%, after reaching 2.479%, its lowest since March 4.

On March 5, German long-dated yields recorded the biggest daily rise in decades as German parties reached an agreement for a massive ramp-up in infrastructure and defence investment.

"Unlike the 1930s, this is not a global trade war. China and the EU, for instance, have less incentive to engage in trade hostilities as a result of U.S. policy," said Paul Donovan, chief economist at UBS Wealth Management.

ECB policymaker Isabel Schnabel said that the euro zone economy's long-standing structural headwinds have been exacerbated by a surge in uncertainty, which may get even worse in the wake of U.S. trade tariffs.

Italian government bonds underperformed their peers in the euro area as investors perceive them as carrying higher risk.

Italy's 10-year yield IT10YT=RR was flat at 3.75%. The yield gap between BTPs and Bunds DE10IT10=RR -- a gauge of risk premium investors ask to hold Italian debt – reached 126 bps, its highest since November 27.

The yield gap between French and German bonds DE10FR10=RR rose to 77 bps.