Euro zone bond yields around two-month lows on inflation optimism

Euro zone bond yields sat at their lowest in two months on Wednesday, a day after cooler-than-forecast U.S. inflation data reinforced expectations the Federal Reserve was finished with rate hikes, sending yields down on both sides of the Atlantic.

Euro zone bond yields sat at their lowest in two months on Wednesday, a day after cooler-than-forecast U.S. inflation data reinforced expectations the Federal Reserve was finished with rate hikes, sending yields down on both sides of the Atlantic. Also in the mix was a ruling from Germany's constitutional court that the government's re-allocation of 60 billion euros ($65 billion) of unused debt from the pandemic era to a climate fund was illegal, triggering tensions in budget negotiations within the country's ruling coalition.

Germany's 10-year yield dropped to 2.567% in early trading, its lowest since mid-September, and was last roughly flat on the day at 2.59%. The yield on the euro zone benchmark dropped 11.6 basis points (bps) on Tuesday, its most in a month.

That move echoed a 19 bps drop in the 10-year U.S. Treasury yield on Tuesday after the softer-than-expected consumer inflation data, which led markets to bring forward their expectations for a first rate cut to around May. "Our view is that the steepening of global curves from mid- September to late October was due to uncertainty and the difficulty after crucial central bank meetings in working out whether we are at a policy peak or simply a pause," said Richard McGuire, head of rates strategy at Rabobank.

"The soft CPI data was very significant in terms of determining the way forward, and hence the sizable reaction." In September and October, longer dated bond yields rose much more sharply than shorter dated ones, causing yield curves to steepen, or, in current circumstances, become less inverted.

CHOPPY MARKETS AHEAD Markets' attempts to gauge when and how quickly rate cuts will come could see some choppiness in bonds, however. Markets now see it as more likely than not that there will be 100 bps of Fed rate cuts in 2024.

"We find the forecast and timing of these cuts, which are getting closer to the first quarter, a bit much... the volatility that we've seen the bond market because of the repricing is something that we'll see a lot of in the coming months if we get data that goes the other way," said Samy Chaar, chief economist at Lombard Odier. "Pricing expectations for the ECB feel more reasonable in our view because disinflation in Europe has been more convincing than the U.S., and we don't have this doubt about robust domestic demand endangering the inflation outlook."

Market pricing currently reflects the view that a European Central Bank rate cut as soon as April is likely. Investors were also digesting data showing a broad decline in euro zone industrial production in September, European Commission estimates the euro zone economy will grow more slowly this year than previously expected, and cooler-than-anticipated British inflation numbers.

There is also a German 30-year bond auction. Italy's 10-year yield was flat at 4.41%, having earlier hit a two-month low of 4.363%, and the gap between German and Italian 10-year yields was 178 bps, down from as much as 209 bps in mid-October, when worries about Italy's budget gave markets some jitters.

Germany's two-year yield was last at 2.98% and Italy's was down 2 bps at 3.63%, both around their lowest since early September.