Euro zone bond yields edge higher in choppy trade, await U.S. data

Analysts expect borrowing costs to remain in their current range as markets have already priced in that the ECB is close to the end of its tightening cycle no matter what it decides at the next policy meeting. Money markets keep pricing an around 30% chance of a 25 basis points (bps) rate hike at the Sept.

Euro zone government bond yields edged higher in choppy trade on Tuesday after a European Central Bank survey showed consumer expectations for inflation edged up, adding to the case for an interest rate hike. Analysts expect borrowing costs to remain in their current range as markets have already priced in that the ECB is close to the end of its tightening cycle no matter what it decides at the next policy meeting.

Money markets keep pricing an around 30% chance of a 25 basis points (bps) rate hike at the Sept. 14 meeting . They also price a terminal rate at around 3.9%, which means a 60% chance of a rate hike by year-end. The ECB's own Consumer Expectations Survey showed inflation expectations three years ahead rising to 2.4% in July from 2.3% in June, above the ECB's 2% target.

George Buckley, chief economist for Europe at Nomura recalled in a research note that ECB policymaker Isabel Schnabel "has emphasised inflation expectations are important for determining 'the degree of restrictiveness'". "Some solace can be taken from the fact that both short- and long-term inflation expectations are declining", he added.

Germany's 10-year government bond yield, the benchmark for the euro area, was up 2.5 bps at 2.60%. It fluctuated between 2.4% and 2.7% in August. 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.

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 2.5 bps to 4.32%. 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's monetary tightening. It narrowed to around 165 bps from more than 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.