By Amanda Cooper

Short-dated euro zone government bond yields drifted lower on Thursday, as investors dialled down their expectations for the European Central Bank to aggressively raise interest rates this year.

A softer U.S. employment report for June gave the Treasury market some support, which in turn filtered into the euro zone market, where yields edged lower in afternoon trading.

Two-year German Schatz yields (DE2YT=RR), the most sensitive to shifts in expectations for rates and inflation, have fallen 1.6 basis points this week, having touched their lowest level since mid-April, as the oil price has retreated. They were last down 1 bp on the day at 2.50%.

ECB President Christine Lagarde said on Wednesday the risks to euro zone inflation and economic growth were now more broadly balanced than a few weeks ago, given the recent fall in oil prices, which prompted traders to cut the chances of one more rate hike this year to around 71%, from closer to 100% a week ago.

The ECB, in its last policy decision, said risks to growth were skewed to the downside, while inflation risks were skewed to the upside.

Benchmark 10-year Bund yields (DE10YT=RR) were up for a fourth day in a row, trading 3 bps higher at 2.956%.

"Our read of Lagarde's comments is that the ECB would remain on hold if oil prices remain around current levels," Jefferies strategist Mohit Kumar said.

WARSH STICKING TO FED INFLATION TARGET

The euro zone market offered little reaction to data on Thursday that showed U.S. job creation was far slower last month than forecast. The monthly employment report showed just 57,000 workers were added to payrolls in June, compared with expectations for an increase of 110,000.

Money markets showed traders continue to price in at least one rate hike from the Federal Reserve this year.

"With the new Fed chair having placed the focus squarely on inflation, June payrolls are unlikely to shift interest rate expectations on their own," said Julien Lafargue, chief market strategist at Barclays Private Bank and Wealth Management.

"The data may also be distorted as hiring linked to the FIFA World Cup may have temporarily boosted employment in sectors such as leisure and hospitality during the survey period. As a result, markets are likely to place greater weight on the June CPI (Consumer Price Index) report due on 14 July, as inflation data will offer a cleaner read on the economy," he said.

Fed Chairman Kevin Warsh said on Wednesday he would stick firmly to the U.S. central bank's 2% inflation target and "disappoint" anyone who expected loose monetary policy, despite President Donald Trump's call for interest rate cuts.

Since Warsh took over as Fed chief on May 22, U.S. Treasuries have noticeably underperformed other major bond markets, as investors rushed to factor in the possibility of rate hikes this year.

Two-year Treasury yields (US2YT=RR) have barely moved in that time, compared with a drop of nearly 14 bps in German 2-year yields (DE2YT=RR), which have benefited from investors lowering their expectations for the ECB to deliver more than one rate hike this year.

The premium of 2-year Treasury yields over 2-year German (DE2US2=RR) is now around 163 bps, close to its highest since last September, reflecting the rising chances of Fed hikes versus the falling chances of many more from the ECB.