Euro zone yields set to end the week lower, Italian bonds outperform

The Bank of England on Thursday held borrowing costs at a 15-year peak on Thursday, stressing the need to continue fighting inflation, while the Federal Reserve the day before supported market expectations that the U.S. central bank is at the end of its tightening path. Germany's 10-year government bond yield, the benchmark for the euro area, was flat at 2.71% and set to end the week down 12.5 bps.

Euro area sovereign bond yields were on track to end the week lower as money markets increased their bets on rate cuts in 2024, with Italian bonds outperforming their peers.

Bond prices move inversely with yields. Central banks on both sides of the Atlantic left rates unchanged this week while the euro zone's recent economic data has pointed to a weak economy with easing inflation.

The European Central Bank last week hinted at a steady policy ahead while pushing back on expectations for rate cuts any time soon. The Bank of England on Thursday held borrowing costs at a 15-year peak on Thursday, stressing the need to continue fighting inflation, while the Federal Reserve the day before supported market expectations that the U.S. central bank is at the end of its tightening path.

Germany's 10-year government bond yield, the benchmark for the euro area, was flat at 2.71% and set to end the week down 12.5 bps. Money markets priced in almost 50 bps of rate cuts by the European Central Bank by July 2024.

ECB euro short-term rate (ESTR) forwards were at 3.41% -- implying market expectations for a deposit facility rate at 3.51% from the current 4% -- after hitting 3.35% the day before. ECB ESTR forwards are pricing 90 bps of rate cuts in 2024 from around 45 bps in mid-October.

ESTR forwards fully price in the first rate cut by June. U.S. Treasuries led the way recently, with benchmark 10-year yields tumbling to three-week lows on Thursday amid relief that the U.S. government had announced smaller-than-expected increases in longer-dated supply and after Fed remarks about its future policy.

US JOBS DATA Markets will closely watch U.S. jobs data later in the session to determine whether yields have further room to fall.

"By essentially referencing the higher longer rates as reason to withhold further tightening, it (the Fed) has created an awkward interdependency with the market," said Padhraic Garvey, regional head of research Americas at ING. Investors are also awaiting figures euro area unemployment data on Friday as a tight labour market is a source of upside inflationary pressure.

Italy's 10-year government bond yield, the benchmark for the euro area's periphery, dropped one bp to 4.56% and was on track to end the week down 25 bps, its biggest fall since end-May. Such a move drove the gap between Italian and German 10-year yields – a gauge of the risk premium investors ask to hold debt of the euro zone's most indebted countries – to its tightest level since end-September at 181.7 bps.

Strong bond demand led by investors keen on locking in the highest yields in over a decade, along with the ECB's focus on avoiding an excessive widening of spreads, are expected to keep yield gaps between core and peripheral bonds in check. The ECB confirmed last Thursday that it would continue reinvestments from the Pandemic Emergency Purchase Programme (PEPP) until the end of 2024. Still, ECB President Christine Lagarde said the council had yet to discuss the issue.

The ECB can use reinvestments from the PEPP to support bonds of southern Europe's most indebted countries. Lagarde called it the first line of defence against fragmentation – an excess widening of yield spreads among the euro area's bonds, which might hamper monetary policy transmission.