* Germany’s two-year bond yield drops to record low
* U.S. equivalent sneaks up ahead of Fed minutes
* Gap between the two benchmarks widest in 17 years
* Spain, Germany sell new debt
* French centrist Bayrou pulls out of presidential election (Updates with move in French bonds)
By John Geddie
LONDON, Feb 22 (Reuters) - The gap between short-dated German and U.S. government bond yields stood at its widest in nearly 17 years on Wednesday as the former fell to record lows and the latter nudged up in anticipation of rate increase signals.
German two-year yields dropped to minus 0.92 percent , pulling the country’s 10-year yields to a five-week low of 0.24 percent. Analysts said jitters around upcoming French elections have stoked demand for an asset seen as one of the safest in the euro zone.
Bottlenecks caused by the European Central Bank’s bond-buying programme and upcoming regulatory changes have amplified the decline in the yields, which move inversely to prices.
U.S two-year yields have meanwhile been sneaking higher in recent days, reaching 1.24 percent -- within sight of a seven-year high breached at the end of 2016 -- as investors start to price in an outside chance the Federal Reserve will raise interest rates next month.
The U.S. yield reached some 212 basis points above its German equivalent, the biggest gap since early 2000.
Fed Chair Janet Yellen said last week a rate increase in the world’s largest economy would be considered at every policy meeting. Wednesday’s release of the minutes of the central bank’s last meeting are expected to provide more clues on the timing.
Money markets suggest a roughly one-in-five chance the Fed will raise rates next month, according to CME’s FedWatch tool. Some banks call it as high as a 40 percent chance.
Philadelphia Fed President Patrick Harker on Tuesday said he would support a rate increase at the mid-March policy meeting as long as inflation, output and other data continue to show a growing U.S. economy.
“There are a host of special factors driving two-year German bond yields lower and on the other side of the Atlantic we have the Fed contemplating another hike,” ING strategist Martin van Vliet said.
French bonds meanwhile received a boost from the latest twists in the presidential race.
Centrist Francois Bayrou said on Wednesday he was offering an alliance with independent candidate Emmanuel Macron, a move that could give the former investment banker a much-needed boost to reach the runoff in May’s presidential vote.
The news helped ease concerns about the strong showing of far-right, eurosceptic Marine Le Pen, who is expected to make it through to the second round.
France’s 10-year bond yield was down 7 basis points in late trade at 1.01 percent, narrowing the gap over German peers to 74 bps. The French/German yield spread had widened to around 84 bps earlier this week -- its widest since late 2012.
Elsewhere in the euro zone, Spain took more than 14 billion euros of orders for the 5 billion euro bond, set to be priced later on Wednesday, according to IFR.
Berlin sold around 500 million euros at auction in a top-up of its 30-year bond.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets
Additional reporting by Dhara Ranasinghe; Editing by Robin Pomeroy