Euro zone yields mixed on data, market bets on ECB tightening

Euro zone data, which showed only a small drop in underlying inflation, is also unlikely to sway the European Central Bank (ECB), which has pencilled in a ninth consecutive rate hike for July and is eyeing one in September too. U.S. economic data on Thursday solidified the picture of an economy and job market defying predictions of a recession, underpinning pronouncements from the Federal Reserve's chief that there is little room to let up on monetary tightening and affecting expectations about rates in the euro area.

Euro zone government bond yields were mixed on Friday as recent prices data from Europe and the U.S. did little to suggest global central banks would deviate from current tightening plans. The U.S. core Personal Consumption Expenditures (PCE) Price Index - a key inflation gauge for the Federal Reserve - rose 0.3% in May from April, but is unlikely to challenge the Fed's commitment to its current hawkish stance.

Futures tied to the Fed's policy rate, which had before the data priced in a nearly 90% chance of a July U.S. rate increase, now reflect about an 85% probability. Euro zone data, which showed only a small drop in underlying inflation, is also unlikely to sway the European Central Bank (ECB), which has pencilled in a ninth consecutive rate hike for July and is eyeing one in September too.

U.S. economic data on Thursday solidified the picture of an economy and job market defying predictions of a recession, underpinning pronouncements from the Federal Reserve's chief that there is little room to let up on monetary tightening and affecting expectations about rates in the euro area. December 2023 ECB euro short-term rate (ESTR) forwards rose to 3.9%, implying market expectations for a deposit rate of around 4% by year-end. The rate is currently 3.5%.

ECB ESTR forwards no longer imply a 25 basis points (bps) rate cut by the first half of next year as was the case early this week. Germany's 10-year bond yield, the benchmark for the euro zone, was last down 1.5 bps at 2.398%.

Euro area borrowing costs have been range-bound in the last few weeks, with traders unwilling to test their recent highs. Germany's 2-year government bond yield, more sensitive to expectations for policy rates, was up 1 bps at 3.266%. It hit its highest level since October 2008 of 3.385% in early March before fears of a banking crisis led to market bets on policy rates dropping to as low as 3%.

UBS economist Arend Kapteyn said "global core inflation (ex food and energy) has retraced 65% of the pandemic run-up". "That will be little solace to central banks, who would want to see the monthly pace annualizing much closer to target, but it's a significant improvement from earlier in the year," he added in an emailed comment, right after the release of euro area numbers.

The German yield curve marginally eased its inversion on Friday, with the gap between 10-year and 2-year yields tightening to 87 bps after hitting its lowest level since September 1992 on Thursday at 90.5 bps. An inverted yield curve means that markets expect rates to drop in the medium term, and is usually a reliable indicator of a future recession.

Italy's 10-year bond yield, the benchmark for the euro zone periphery, fell 0.5 bps to 4.085%, while the 2-year yield hit its highest level since August 2012 after rising as much as 6 bps to 3.955%. The spread between Italian and German 10-year yields was at 167 bps.

Italian Prime Minister Giorgia Meloni said earlier this week a parliament vote on the European Stability Mechanism (ESM) would not happen, and linked the debate to ongoing discussions on a broader reform of European budget rules. The ESM is a fund created in 2012 after the euro zone sovereign debt crisis to provide a financial firewall for members of the currency bloc.