Euro zone bond yields struggle for direction, await U.S. data

Euro zone government bond yields steadied around the middle of their recent range as investors expect the European Central Bank to be close to the end of its tightening cycle no matter what it decides at the next policy meeting.

Euro zone government bond yields steadied around the middle of their recent range as investors expect the European Central Bank to be close to the end of its tightening cycle no matter what it decides at the next policy meeting. They briefly ticked up after an ECB Survey showed consumer expectations for inflation in the coming years edged up, adding to the case for a rate hike, which would bring the deposit facility rate to 4% from the current 3.75%.

Money markets keep pricing an around 30% chance of a 25 basis points (bps) rate hike at the Sept. 14 ECB meeting . They also price a terminal rate at around 3.9%, which means a 60% chance of a rate hike by year-end. ECB chief economist Philip Lane expressed cautious optimism that inflation was slowing, but said a lot more data was needed before he would be comfortable declaring victory.

Germany's 10-year government bond yield, the benchmark for the euro area, was flat at 2.58%. It fluctuated between 2.4% and 2.7% in August. Later in the session, investors will closely watch the U.S. Treasury's reaction to U.S. economic data after the long weekend. U.S. markets were closed on Monday for Labor Day.

Analysts said that the Job Openings and Labor Turnover Survey (JOLTS) and Personal Consumption Expenditures (PCE) releases constitute enough evidence of progress towards disinflation and labour market rebalancing to keep the Federal Reserve on hold in September. Italy's 10-year government bond yield, the benchmark for the euro area periphery, rose 1 bp to 4.30%.

The spread between Italian and German 10-year yields - a gauge of investor sentiment towards the euro zone's more indebted countries - was at 171 bps after reaching on Monday its widest level in two weeks at around 172 bps. The Italian spread has been remarkably resilient since the end of 2022 despite the ECB monetary tightening.

It dropped to around 165 bps from above 250 bps in September 2022 as the government, led by Giorgia Meloni, stuck to European Union budget rules while the Italian economy grew. "(Italy's) BTP and (Portugal's) PGB spreads still look too tight on our fundamental model based on consensus expectations for the country's growth, budget balance and inflation," Citi analysts said in a note to clients.

Italy is preparing to raise its 2023 budget deficit above the target of 4.5% of gross domestic product (GDP). Italy's GDP shrank by 0.4% in the second quarter, according to data released last Friday that cast a shadow over the country's economic prospects.