Short-dated euro zone yields touch highest since March

But markets still expect the Fed to tighten policy later in the summer as core inflation - which strips out volatile energy and food prices - remains sticky, while investors have bought into the central bank's communication that rates will stay higher for longer. "Repricing in Fed expectations has been massive in the last two months after the banking crisis and debt ceiling was solved," said Jussi Hiljanen, chief strategist, EUR and USD rates at SEB.

Short-dated euro zone yields touched multi-month highs on Wednesday ahead of the U.S. Federal Reserve's policy decision, which is expected to pause interest rate hikes after data showed inflation moderated last month. But markets still expect the Fed to tighten policy later in the summer as core inflation - which strips out volatile energy and food prices - remains sticky, while investors have bought into the central bank's communication that rates will stay higher for longer.

"Repricing in Fed expectations has been massive in the last two months after the banking crisis and debt ceiling was solved," said Jussi Hiljanen, chief strategist, EUR and USD rates at SEB. "Market pricing for another July hike is pretty high and I have difficulty seeing why that will fundamentally change anytime soon."

In March, traders had priced in as many as three, 25-basis-point (bps) rate cuts from the Fed by the end of the year when troubles at regional U.S. banks prompted worries of a full-blown banking crisis. But as concerns about the health of the banking system subsided, markets began to refocus on the inflation and growth outlook, and with inflation remaining above the central bank's target, expectations are that interest rates will remain higher for longer.

The European Central Bank (ECB) announces its policy decision on Thursday, when a 25 bps rate rise is baked into market pricing, while a majority also expects another rate rise in July. November 2023 ECB euro short-term rate (ESTR) forwards were around 3.7%, implying market expectations for an ECB deposit rate at 3.8%, or around two more 25 bps hikes.

"Expectations are cemented for tomorrow's meeting and another 25 basis point hike is almost fully priced for July. I think market pricing is correct there," SEB's Hiljanen said. Germany's policy-sensitive two-year yield was last up 1.5 bps at 3.05%, after earlier hitting its highest level since March 10 at 3.095%.

Two-year yields in France and Spain also hit their highest level since mid-March. Germany's 10-year yield, the euro zone's benchmark, was up 2.5 bps at 2.45%, after rising 4.5 bps on Tuesday.

Analysts said Wednesday's trading in euro zone government bonds could be calmer than usual given the Fed's rate decision arrives after the market close and ahead of the ECB. Italy's 10-year yield was up 3 bps at 4.10%, meaning the closely-watched yield gap between Italian and German 10-year yields tightened to around 160 bps, not far from its tightest level since April 2022 at 158 bps.

Yields in Britain steadied but the two-year yield briefly rose to its highest level in 15 years after unexpectedly strong labour market data on Tuesday raised expectations for further tightening from the Bank of England.