Euro zone yields fall as ECB hikes but signals end of tightening

Euro zone government bond yields fell on Thursday after the European Central Bank hiked interest rates by 25 basis points to 4% but signalled it was likely finished with its tightening policy.

Euro zone government bond yields fell on Thursday after the European Central Bank hiked interest rates by 25 basis points to 4% but signalled it was likely finished with its tightening policy. Germany's 10-year bond yield, the bloc's benchmark, was last down 6 basis points (bps) at 2.594%. The yield, which moves inversely to the bond's price, stood at 2.638% just before the decision.

The increase in rates came as the ECB upgraded its inflation forecast for 2024 to 3.2%, confirming Reuters reporting, but said inflation would cool to 2.1% in 2025. Inflation in the euro zone was at 5.3% in August, unchanged from the previous month and well above the ECB's 2% target. Yet it is down sharply from the peak of 10.6% in Oct. 2022.

The central bank's Governing Council said in a statement that "the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target". Andrew Kenningham, chief Europe economist at Capital Economics, said: "The ECB's decision to raise interest rates by a further 25 bps today probably brings the current tightening cycle to an end.

"But given the strength of underlying inflation, we expect rates to remain at this level for at least a year, even though the economy seems to be heading for a recession." Italy's 10-year bond yield was 12 bps lower at 4.341%. That put the gap between Italy and Germany's 10-year yields at around 173 bps, from 178 bps before the ECB decision.

The German 2-year bond yield, which is sensitive to interest rate expectations, was last down 1 bp at 3.159%, effectively unchanged from the European morning session. "Overall, this (decision) bolsters the appeal of high-quality income in portfolios, in our view," said Ann-Katrin Petersen, senior investment strategist at the BlackRock Investment Institute.

"For longer maturities, we prefer euro area nominal government bonds over longer-dated U.S. Treasuries." At the post-decision press conference, ECB President Christine Lagarde did not completely rule out a further increase.

"The focus is going to move, going forwards, to the duration, but that is not to say - because we can't say that now - that we are at peak," she said. Yet analysts and markets saw little prospect of another increase.

"From now on, the focus of the ECB debate will shift to the length of the likely rate plateau," said Holger Schmieding, chief economist at Berenberg. "Unlike the U.S. Fed, which we expect to start cutting rates in spring 2024, the ECB will probably stay largely put next year, in our view."