Euro zone bond yields tick up as markets scale back rate cut bets

Euro zone government bond yields were on track to close the week higher as investors balanced recession fears against comments from European Central Bank policymakers pushing against market expectations for rate cuts in 2024. Germany's 10-year government bond yield, the benchmark for the euro area, rose 3 basis points (bps) to 2.65%, a 1-1/2-week high.

Euro zone government bond yields were on track to close the week higher as investors balanced recession fears against comments from European Central Bank policymakers pushing against market expectations for rate cuts in 2024. Borrowing costs rose the day before after economic data showed European economies were faring less badly than expected. Separate data on Friday showed that U.S. business activity held steady in November, boosting yields somewhat.

ECB policymaker Robert Holzmann, seen as a policy hawk, reiterated that another rate hike was possible, after Belgian policymaker Pierre Wunsch warned about "too optimistic" bets on future cuts. Germany's 10-year government bond yield, the benchmark for the euro area, rose 3 basis points (bps) to 2.65%, a 1-1/2-week high. It was on track to end the week up 6 bps.

Money markets scaled back expectations for policy rate reductions this week and are currently pricing in 83 bps by December 2024 from 100 bps last Friday. Policy rates derivatives also imply a 55% chance of a rate cut in April, down from around 95% last week.

"Overall, it (tight financial conditions) might lessen the need for officials to push back more aggressively (against expectations for rate cuts), although some would point out the often-cited fragility of inflation expectations," Benjamin Schroeder ING senior rate strategist argued in a note. German business morale improved less than expected in November, a survey showed on Friday.

"The Ifo current conditions index remains consistent with a severe recession despite today’s rise," said Bradley Saunders, economist at Capital Economics. German Finance Minister Christian Lindner will propose a supplementary budget for this year, which includes the suspension of limits on new borrowing, but vowed the ruling coalition will follow a strict course of austerity after a budget crisis caused by a court ruling last week.

Analysts warned about a significant impact from a substantial economic growth hit if the German government found no solution to the budget crisis. Italy's 10-year government bond yield, the benchmark for the euro area's periphery, was flat at 4.397%.

The spread between Italian and German 10-year yields – a gauge of the risk premium investors ask to hold debt from the bloc's most indebted countries - was at 173 bps. It hit 169.5 bps, its tightest level since Sept. 21, on Tuesday after Moody's improved the outlook of Italy's credit rating. Policymakers should discuss at their meeting next month whether to wind down bond reinvestments under the Pandemic Emergency Purchase Programme (PEPP) early, the ECB's Holzmann said, suggesting to reduce reinvestments step by step as of March.

The ECB can use reinvestments from the PEPP to support bonds of southern Europe's most indebted countries. ECB President Christine 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. The central bank confirmed at its last policy meeting in October it would continue reinvestments from the PEPP until the end of 2024. However, Lagarde said the council had yet to discuss the issue.

Several analysts expect PEPP reinvestments to end at its deadline in December next year. The yield spread between Dutch and German 10-year yields was at 33 bps after the party of anti-EU, far-right veteran politician Geert Wilders won 37 out of 150 seats in Wednesday's election, well ahead of 25 seats won by its closest rival.

The yield spread hit 35.5 bps, a two-week high, on Thursday after fluctuating between 40 and 25 bps since July. Dutch party leaders met on Friday to begin the difficult and lengthy process of trying to build a coalition.