Euro zone bond yields near two-week high with ECB rate in focus

Euro zone government bond yields rose on Tuesday after a European Central Bank (ECB) survey showed consumer expectations for inflation edged up, adding to the case for an interest rate hike.

Euro zone government bond yields rose on Tuesday after a European Central Bank (ECB) survey showed consumer expectations for inflation edged up, adding to the case for an interest rate hike. The ECB's 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.

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.

ECB policymaker Isabel Schnabel "has emphasised inflation expectations are important for determining 'the degree of restrictiveness,'" George Buckley, chief economist for Europe at Nomura, said in a research note. "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, rose to its highest level since Aug 23, and was last up 3 bps at 2.60%. Italy's 10-year government bond yield, the benchmark for the euro area periphery, rose to a two-week high, up 4.6 bps to 4.34%.

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. Analysts also kept eyes on Treasury yields, with the 10-year yield rising 8 bps to 4.25% as the U.S. opened after Monday's holiday.

They 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. The spread between Italian and German 10-year yields - a gauge of investor sentiment towards the euro zone's more indebted countries - was at 172 bps after reaching its widest level in two weeks.

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.