Euro zone sovereign bond yields edge lower ahead of inflation data

Euro zone government bond yields edged lower on Monday, with investors awaiting inflation data due later this week which could affect expectations for interest rate cuts in 2024. Money markets scaled back expectations for policy rate reductions last week as European Central Bank policymakers warned about "too optimistic" bets on future cuts.

Euro zone government bond yields edged lower on Monday, with investors awaiting inflation data due later this week which could affect expectations for interest rate cuts in 2024.

Money markets scaled back expectations for policy rate reductions last week as European Central Bank policymakers warned about "too optimistic" bets on future cuts. Germany's 10-year government bond yield dropped 1.5 bps to 2.63%. On Friday last week, it hit 2.663%, its highest level since mid-November.

"Disinflation is now a widespread phenomenon. In addition, although the outbreak of another conflict in the Middle East led to temporary fears of spiralling energy prices, no such thing materialized," said Bruno Cavalier, chief economist at Oddo. "The hawk's last argument is to highlight the upsurge in wages, but this is the most lagging indicator in the business cycle. There is every reason to debate monetary easing in the Eurozone," he added.

Money markets are currently pricing in 83 bps of rate cuts by December 2024 from 100 bps in mid-November, while pricing an around 55% chance of a first 25 bps rate cut in April from about 90% chances ten days ago. Analysts expect an economic slowdown in 2024 that will lead ECB policymakers to ease their monetary policy aggressively.

"The euro area is on course for nearly two years of stagnation by mid-2024 when the recovery slowly starts," Deutsche Bank said in its 2024 outlook. "The ECB will likely cut 100 bps from June to year-end 2024." The budget crisis in Germany is also in focus as its outcome might affect the bloc's fiscal policy which European Union member states are currently discussing.

German Chancellor Olaf Scholz would ask parliament to lift Germany's debt brake after a constitutional court ruling forced his government to freeze most of its new spending commitments. "Germany will probably suspend the debt brake for 2023, tighten fiscal policy for 2024 and 2025," said Holger Schmieding, adding he sees a possible reform of the debt brake after September 2025, assuming next government will be a coalition of centre-right and centre-left parties again.

"It remains an open question whether it (the German budget crisis) may affect the ongoing discussions about a reform of the EU's fiscal rulebook." Some analysts reckoned that easier fiscal rules in Germany could lead to a European agreement more focused on growth than on stability, as Italian Prime Minister Giorgia Meloni urged.

Italy's 10-year government bond yield, the benchmark for the euro area's periphery, fell 3 bps to 4.37%. The spread between Italian and German 10-year bond yields -- a gauge of premium investors ask to hold debt of the bloc's most indebted countries – was at 172.5. It hit last week 169.5 bps, its tightest since Sept. 21.