Euro zone yields around 2-week highs on inflation concerns

Euro zone borrowing costs edged lower on Thursday, with long-dated yields around their 2-week highs on inflation fears and after comments from European Central Bank's policymakers. Investors have adjusted their positioning before next week's ECB meeting, with markets increasing their bets on a 25 basis points (bps) rate hike but still pricing less than a 50% chance.

Euro zone borrowing costs edged lower on Thursday, with long-dated yields around their 2-week highs on inflation fears and after comments from European Central Bank's policymakers.

Investors have adjusted their positioning before next week's ECB meeting, with markets increasing their bets on a 25 basis points (bps) rate hike but still pricing less than a 50% chance. German industrial production fell slightly more than expected in July, confirming the challenges Europe's largest economy faced and bringing some relief to the recent bond selloff. Bond prices move inversely with yields.

Germany's 10-year government bond yield, the benchmark for the euro area, dropped 1.5 bps to 2.64%, breaking a four-day rising streak. It hit earlier in the session 2.664%, its highest level since Aug. 22. Comments from Bank of France head Francois Villeroy de Galhau "deserve special attention as he has often predicted the consensus view in the governing council," said Hauke Siemssen, rates strategist at Commerzbank.

Bank of France head said on Wednesday ECB needs to persevere in its fight against inflation. ECB policy hawks Peter Kazimir and Klaas Knot said on Wednesday, just hours before the bank goes into a week-long quiet period, the ECB should raise rates and that investors betting against an ECB rate increase are possibly underestimating the likelihood of it happening.

ECB euro short-term rate forwards are currently pricing in an around 40% chance of a 25 bps hike, from a 20% chance last week. Italy's 10-year government bond yield, the benchmark for the euro area's periphery, fell 1.5 bps to 4.40%. The spread between Italian and German 10-year yields -- a gauge of investor sentiment towards the euro zone's more indebted countries -- was at 174 bps after briefly hitting its widest level since July 12 at 175.40.

Citi analysts have said the yield spreads of Italy and Portugal look too tight on their fundamental model based on consensus expectations for the country's growth, budget balance and inflation. Warnings about resilient inflation pressures are coming from several directions.

Brent crude futures spiked earlier in the week after Saudi Arabia and Russia, the world's top two oil exporters, extended voluntary supply cuts to the year-end. They were falling on Thursday after a nine-session winning streak. U.S. Treasury yields were higher on Wednesday after economic data showed the services sector unexpectedly accelerated in August, indicating that inflation pressures remain firm.

The ECB's Consumer Expectations Survey provided mixed signals, with inflation expectations three years ahead rising to 2.4% from 2.3% in June, while long-term and short-term forecasts were declining, analysts said.