UPDATE 2-Decade low U.S. manufacturing data curbs euro zone bond selloff

Eurozone bond yields halted their rise on Tuesday after U.S. manufacturing data hit a decade low, reviving fears about a global slowdown on the same day eurozone inflation in September fell below 1%.

The Institute for Supply Management's U.S. manufacturing activity index fell to its lowest level since June 2009, reversing a drop in the eurozone bond market that took place in earlier trade. Government bond yields slumped to record lows in early September as fund managers, fearful of an economic downturn, scrambled into government debt. But investors have since been cutting back on their bond holdings, believing European Central Bank monetary policy easing may have run its course for now.

ECB President Mario Draghi's emphasis again on Monday on the need for fiscal policy to support the bloc's long-term growth prospects lifted yields at the start of the week. On Tuesday, however, there was a more technical explanation for the higher yields. After the Bank of Japan this week cut purchases in long tenors, investor demand for a 10-year bond auction was weak and government bond prices slumped.

Most 10-year bond yields were flat on the day in late trade, with Germany's 10-year benchmark at -0.57%, having risen as much as 5 basis points earlier. Eurozone bond yields' rise had overshadowed the "flash" release of September eurozone inflation earlier in the session. Prices grew at 0.9%, below a forecast by economists polled by Reuters for 1%, and adding to concerns that ECB stimulus is doing little to revive inflation.

However, weak readings in individual eurozone countries over the last few days ensured expectations for the overall number had already been priced in, said Antoine Bouvet, a rates strategist at ING. He said the rise in bond yields earlier on Tuesday did not reflect the fundamentals of a deteriorating outlook for the eurozone economy.

"There are still some adjustments that markets need to make to weaker economic indicators," he said, referring to poor Purchasing Managers' Index readings and linking Tuesday's higher bond yields to the Japanese government bond market selloff. On Tuesday, a September survey showed eurozone manufacturing activity had contracted at its steepest rate in almost seven years.

The widely watched 5-year, 5-year breakeven forward, a market gauge of eurozone inflation expectations, which had risen earlier, inched back towards its weakest level in July following the U.S. data, at 1.153%. Peter Chatwell, rates strategist at Mizuho Bank, said falling inflation expectations "should be something to worry about" and should be enough to "allow the market to firm up."

Analysts said the key focus this week was on the launch of the ECB's new euro short-term rate ESTR, which will be published for the first time on Wednesday, as the ECB ceases to publish EONIA, the current overnight benchmark. (Additional reporting by Yoruk Bahceli; Editing by Susan Fenton and Mark Potter)