Euro zone bonds rally but on track for heavy monthly loss

The 10-year U.S. Treasury yield, which sets the tone for borrowing costs around the world, hit its highest since 2007 on Thursday at 2.688% and has jumped 45 bps this month. Data on Friday showed that euro zone inflation cooled more than expected in September, coming in at 4.3% year-on-year from 5.2% in August.

Euro zone government bonds rallied on Friday, helped by a lower than expected euro zone inflation number, but were on track for a heavy monthly and quarterly loss as investors come to terms with the new high interest-rate environment.

Germany's 10-year government bond yield, the benchmark for the euro area, was down 15 bps at 2.818% as European markets recovered from a brutal Thursday that saw the yield jump 14 bps. Yields fall when prices rise, and vice versa. The yield hit its highest level since 2011 on Thursday at 2.98%. By Friday, it was set to end the month up 35 bps, its biggest rise since February, and was heading for a 43 bp increase for the quarter.

"The key question is whether the sell-off can continue, or it's an opportunity to buy the market," said Mohit Kumar, chief economist for Europe at Jefferies. "From the macro perspective, we do not see the sell-off as having many legs." Analysts say a number of factors have driven the sell-off in bonds, chief among them investors reeling in their bets that central banks will cut interest rates any time soon.

That in turn has been driven by strength in the U.S. economy and a rise in oil prices which has fuelled concerns that inflation may be harder to squeeze out of economies than previously hoped. The 10-year U.S. Treasury yield, which sets the tone for borrowing costs around the world, hit its highest since 2007 on Thursday at 2.688% and has jumped 45 bps this month.

Data on Friday showed that euro zone inflation cooled more than expected in September, coming in at 4.3% year-on-year from 5.2% in August. It was the lowest reading in two years. Separate figures showed that the core U.S. personal consumption expenditure inflation - a closely watched measure of underlying price pressures - fell to 3.9% in August from 4.3% in July.

Italy's 10-year yields were down 16 bps at 4.766% but were set to end the week up 18 bps. The Italian government said on Wednesday that its budget deficit would be considerably higher than previous thought over the next two years. That triggered a sell-off in its bonds pushing the yield on the 10-year bond to 4.96%, its highest since 2012.

Jack Allen-Reynolds, deputy chief euro zone economist at Capital Economics, said that the fall in the bloc's inflation rate "reinforces our view that the ECB has finished raising rates". The ECB raised borrowing costs to 4% earlier this month but signalled it was likely done tightening monetary policy. Allen-Reynolds said the ECB is unlikely to start cutting rates until late 2024, however.

Germany's two-year yield, which is sensitive to expectations for policy rates, was down 9 bps at 3.206%. It was set to end the week down 4 bps, in stark contrast to yields on longer-dated bonds. Investors are now shifting their focus to new European Union fiscal rules and government budget plans, which could be approved by year-end, and risks of recession in the euro zone, analysts said.

"Duration (longer-dated bonds) aversion is feeding on itself," said Christoph Rieger, head of rates and credit research at Commerzbank. "After major levels were taken out on no major news, investors feel vindicated in their preference for cash at a time when supply prospects for next year appear to be getting more challenging."