UPDATE 1-Everything but the cut: European bond yields lower on easing expectations

Eurozone government bond yields began to reverse some of the rises seen after Thursday's European Central Bank meeting, where policymakers left rates unchanged but opened the door to more easing, underwhelming investors who had hoped for more. Expecting ECB President Mario Draghi to prepare the ground for another round of monetary easing, if not a rate cut, investors had piled into eurozone government bonds before the meeting, but some of the positionings were unwound during Draghi's comments to the press.

Draghi told reporters "this (economic) outlook is getting worse and worse", increasing the need for stimulus. But investors latched on to his comment that the ECB wanted to see more projections of how the economy was performing before taking action. Commentators were quick to point out that Draghi has delivered everything but the cut - signaling both tiering and the resumption of asset purchases - and eurozone bond yields began to retreat from the rises seen in both the core and the periphery.

German 10-year bond yields were around one basis points lower at -0.373%, heading back down towards the record low of -0.422%, recorded on Thursday. Most other 10-year yields in the bloc were also around two basis points lower,

"The ECB's dovishness has been massively under-estimated," Mizuho analysts wrote in a note on Friday. With tiering now likely, they said, the ECB has no effective lower bound to its policy rates, meaning that "real rates can now be pushed to extremely negative levels." However, the bank does not believe that the next easing steps will be successful.

Focus now turns to September. A rate cut at the ECB's September meeting appears certain, four sources close to the discussion told Reuters on Thursday. Government bond purchases and a revamped policy message were also likely, they said. Money markets are now pricing in an 88% chance of a 10-basis-point hike at the ECB's September meeting.

Italy and Greece were both underperforming with the former's yields up to seven basis points higher as investors refocus on political posturing by League leader Matteo Salvini. Economy Minister Giovanni Tria's job could be at risk if he does not show enough courage in reducing taxes next year, Salvini said on Friday.

"He (Salvini) is providing some veiled threats to the prime minister and his coalition partner that they need to tow the Salvini line, otherwise they risk upsetting the apple cart," said Rabobank strategist Matt Cairns. Italy's spread over top-rated Germany widened to 195 basis points having fallen below 180 bps earlier this week, while its 10-year government bond yield was last at 1.58%, up 6 bps on the day.

Investors appear unperturbed by political ructions in Spain, however, where parliament rejected Pedro Sanchez's bid to be confirmed as prime minister on Thursday. That put the country on a path to what would be its fourth national election in as many years - unless he succeeds in another attempt. Spanish 10-year bond yields have fallen some 120 basis points since the start of the year and were last seen at 0.342%.