Updates at 1145 GMT

By Yoruk Bahceli

Oct 1 (Reuters) -Government bonds rallied on Tuesday as euro zone inflation data boosted the case for faster European Central Bank rate cuts, while the dollar firmed after comments by Federal Reserve Chair Jerome Powell reined in bets on a second big U.S. rate cut.

Oil prices fell even as Middle Eastern tensions escalated after Israel's ground incursion in Lebanon appeared to be getting underway.

Euro zone inflation data helped the bond rally as it came in below the ECB's 2% target, boosting the case for speedier rate cuts than traders have been betting on.

Germany's 10-year bond yield DE10YT=RR fell over 8 basis points (bps) to its lowest since January. U.S. Treasury 10-year yields US10YT=RR were last down 6 bps at 3.74%.

"The dovish repricing of ECB expectations (is) continuing as markets increasingly price an October cut," said Michael Brown, senior strategist at Pepperstone.

The U.S. dollar USD= was 0.3% higher against a basket of currencies as traders reckoned the Fed was now more likely to cut rates by 25 bps, rather than 50 bps, in November.

European stocks, meanwhile, edged higher with the STOXX 600 index .STOXX up 0.4%. But U.S. stock futures indexes were mixed .ESc1, NQc1, 1YMcv1

HURRY OR NOT?

Inflation data showed euro zone price growth dropped to 1.8% in September, below expectations and the lowest since mid-2021.

Traders now see more than an 85% chance of a 25 bps rate cut at the ECB's Oct. 17 meeting, a move they had reckoned was unlikely just over a week ago.

Tuesday's inflation print came after ECB President Christine Lagarde said on Monday the bank was increasingly confident inflation would fall to its 2% target.

Lagarde said this would be reflected in the ECB's next policy move, a hint at a rate cut that traders have been betting on since business activity data weakened the bloc's growth outlook last week.

That contrasted with the United States, where Fed Chair Powell indicated on Monday the central bank would likely stick to quarter-percentage-point cuts following a 50 bps move last month, after new data boosted confidence in economic growth and consumer spending.

"This is not a committee that feels like it is in a hurry to cut rates quickly," Powell said.

Traders on Tuesday were pricing in a 40% probability of a 50-bp Fed cut next month, down from 53% on Friday. FEDWATCH

Given the Fed's current focus on the labour market, Tuesday's data on job openings for August and the ISM manufacturing survey for September will be important for rate expectations and the dollar, said economist Kristina Clifton at the Commonwealth Bank of Australia.

On Friday, U.S. non-farm payrolls data will provide further clarity on the labour market.

In commodities, oil prices dropped on Tuesday given the prospect of additional supply amid lacklustre global demand growth, offsetting worries that an escalating Middle East conflict could disrupt exports in the key producing region.

Israel said intense fighting erupted with Hezbollah in south Lebanon on Tuesday after its paratroops and commandos launched raids there, at the start of a ground incursion following devastating airstrikes against Hezbollah's leadership.

Brent crude futures LCOc1 were last down 0.7% to $71.23 a barrel, having dropped as low as $69.91 in earlier trade. O/R

"There's been relatively little impact from Middle East news flow, which is perhaps unsurprising with the market seemingly having become somewhat immune to developments in the region," said Pepperstone's Brown.

Elsewhere, France's government bonds, recently under renewed pressure, outperformed.

Their yields dropped as much as 11 bps, the biggest daily fall since May, helped by a report that Prime Minister Michel Barnier is planning tax hikes as the country's already high budget deficit risks coming in even wider than expected.

The yen JPY=EBS steadied around the middle of its range against the dollar over the past month, after a volatile two days as traders sized up Japan's incoming prime minister and his cabinet.

Earlier, Japan's Nikkei .N225 stock index rose nearly 2% after shedding 4.8% on Monday.

Spot gold XAU= was 0.6% higher around $2,650 per ounce, not far from the record high of $2,685.42 touched on Thursday that rounded off a 13% rise during the third quarter.

Reporting by Yoruk Bahceli and Ankur Banerjee; Editing by Emelia Sithole-Matarise and Mark Potter

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