German 10-year yield hits fresh 4-1/2-week high, focus on inflation

The European Central Bank (ECB) must keep raising interest rates even if a recession in Germany is increasingly likely, as inflation will stay uncomfortably high all through 2023, Bundesbank President Joachim Nagel told a German newspaper during the weekend. Germany's 10-year government bond yields rose 1.5 basis points (bps) to 1.246%, its highest since July 21.

German 10-year government bond yield hit a fresh 4-1/2-week high as inflation fears kept investors focused on expectations for more monetary tightening. The European Central Bank (ECB) must keep raising interest rates even if a recession in Germany is increasingly likely, as inflation will stay uncomfortably high all through 2023, Bundesbank President Joachim Nagel told a German newspaper during the weekend.

Germany's 10-year government bond yields rose 1.5 basis points (bps) to 1.246%, its highest since July 21. "We expect more monetary tightening in the next few months, with a 10-year Bund yield at 1.75%," said Francis Yard, global head of rates research at Deutsche Bank.

"Monetary policy is not even as tight as it was in 2018. Real rates are still at extremely low levels, while core inflation is around the mid-single digit," he added. Investors are awaiting the purchasing manager index (PMI) data due on Tuesday and Germany's Ifo index later in the week, which might provide recession signals and reduce the prospect of a more aggressive ECB.

"The August PMIs aren't likely to paint a rosy economic picture, so some safe-haven demand should emerge for bonds," ING analysts said. Italy's 10-year yield rose 2 bps to 3.509%, after hitting its highest since July 22 at 3.533% last Friday.

The spread between Italian and German 10-year government bond yields was at 226 bps after hitting its widest in 3-1/2 weeks of 229.4 bps last Friday on expectations of more monetary tightening, with some analysts citing political concerns ahead of the Sept. 25 Italian elections. Peripheral government bonds are the biggest beneficiaries of the monetary stimulus the ECB has been withdrawing, and inflation data recently boosted expectations of more tightening.

The Italian-German spread widened to 260 bps after the collapse of the government led by Mario Draghi but tightened then to around 200 bps. Some analysts worried measures to reduce taxes and increase pension spending by a right-wing government might collide with the European Union rules.

According to the latest opinion polls, a conservative bloc is in pole position to win a parliamentary majority in the Italian elections. "Despite the more conciliatory attitude towards the EU compared with the 2018 election, the right's key policy pledges have not materially changed," Citi analysts said, citing pledges of significant tax cuts and higher pension spending.

"Many (of these pledges) are likely to eventually put Italy on a collision course with Brussels," they added.