German short-dated government bond yields fell to multi-year lows, while the euro tumbled to two-year lows on Friday as markets ramped up European Central Bank rate cut bets after data showed a sharp decline in euro area business activity.

Business activity in the euro zone took a sharp turn for the worse this month as the bloc's dominant services sector contracted and manufacturing sank deeper into recession, a survey showed on Friday.

France slowed at the sharpest pace since early this year, while Germany's business activity fell for a fifth month running and at the quickest rate since February.

The reaction from investors was swift as they drove euro zone government bond yields down on expectations of further ECB rate cuts. The euro briefly fell as much as 1%.

Money market pricing suggested that investors now price more than a 50% chance of a 50 basis point (bps) rate cut at the ECB's December meeting, up from 20% before data.

A 25 bps cut is fully discounted.

Traders also priced in an ECB deposit facility rate at around 1.80% in July, down from 1.95% before PMI figures.

"Markets are reacting because they think the ECB needs to do more," said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, adding that he still expects the ECB to cut by 25 bps in December.

Germany’s 2-year bond yields, more sensitive to expectations for the ECB policy rates, hit 1.98%, its lowest level since December 2022.

Bond yields were down across the euro area with Italian 2-year yields 9 bps lower at 2.49%.

Bank stocks, which have benefited from higher interest rates since 2022, fell as much as 2.1% as markets moved to price in more rate cuts from the ECB following the weak PMI data.

The pan-continental STOXX 600 index was up 0.4% on the day as of 10:08 GMT, having been higher by 0.75% before the data.

Markets are also closely watching developments on the geopolitical front, as investors have bid for safe-haven government bonds.

Russia fired a hypersonic intermediate-range ballistic missile at the Ukrainian city of Dnipro on Thursday. North Korean leader Kim Jong Un has accused the United States of ramping up tension and provocations, saying the Korean peninsula has never faced a greater risk of nuclear war, state media KCNA said on Friday.

Germany's 10-year yield, the benchmark for the euro area, was down 6.5 bps at 2.25%, after hitting its lowest level since October 21. It was up 2 bps before the data.

(Reporting by Stefano Rebaudo and Dhara Ranasinghe; additional reporting by Samuel Indyk. Editing by Elisa Martinuzzi.)