Euro zone yields edge up as investors brace for Powell testimony

Euro zone government bond yields rose slightly on Wednesday as investors braced for Federal Reserve Chair Jerome Powell's testimony before Congress. Short-dated yields hit new highs and market bets on policy rates rose to 4% earlier in the session as data from Britain was a stark reminder that the fight against inflation is not over and central banks might need to tighten further.

Powell delivers semiannual monetary policy testimony to the U.S. House Financial Affairs Committee at 1400 GMT. "There is more than a suspicion that the June pause in (the Fed) policy (rate hiking) was part of a compromise to appease the Fed's factions with the promise of a hike in July the quid pro quo," said Paul Donovan chief economist at UBS Global Wealth Management in his morning comment to clients.

"Powell has tended to be reactive, focusing on current inflation rather than considering where inflation is going." Germany's 10-year government bond yield, the euro area's benchmark, rose 0.5 basis points (bps) to 2.34%.

British consumer price inflation was higher than expected in May, leading investors to ramp up their bets on the Bank of England's next moves on rates. "Being specific to the UK economy – and reflecting the tightness of the labour market – are the strong wage growth numbers," said Gero Jung, chief economist at Mirabaud AM.

"Between February and April, average earnings grew at a near record pace of 7.2% (annualized) – signalling that there are likely strong effects from a wage-price spiral," he added. Euro area short-dated yields have climbed towards levels seen before fears of a banking crisis disrupted financial markets in March, sending market bets on where policy rates would peak to around 3%.

Germany's 2-year bond yield, the most sensitive to policy rates expectations, rose to its highest since March 10 at 3.235% before dropping to 3.18%, up 1.5 bps on day. It hit its highest level since October 2008 at 3.385% on March 9. December 2023 forwards on European Central Bank (ECB) euro short-term rate (ESTR) was at 3.9%, implying market expectations for an ECB depo rate at 4% by year-end.

Analysts said that Bank of France Governor Francois Villeroy de Galhau said on Tuesday the ECB has completed most of its interest rate increases, and possible further hikes would be less critical in fighting inflation than the duration of tight monetary policy. They also recalled Lithuanian policymaker Gediminas Simkus stating on Tuesday what markets have been pricing since the ECB policy meeting last week, that a rate hike in September wouldn't be a surprise.

Italy's 10-year bond yield, the benchmark of the periphery, rose 2 bps to 4.04%, with the spread between Italian and German 10-year yields at 162 bps after hitting last week its tightest level since April 1 below 150 bps.