Euro zone yields drop as lower inflation spurs rate cut bets

Euro zone sovereign bond yields fell and money markets increased their bets on future interest rate cuts on Wednesday after German and Spanish inflation eased by more than expected in November. The inflation rate in Germany fell to 2.3% this month, data from the federal statistics office showed, below expectations in a Reuters poll of 2.6%.

Data released earlier from German states had indicated a slowdown in price pressures, while Spain's 12-month inflation rate fell to 3.2% in November, below expectations of 3.7%. "As disinflation is not only a German phenomenon but widely spread across the entire eurozone, the ECB runs the risk of underestimating the disinflationary momentum as much as it underestimated the inflationary momentum two years ago," said Carsten Brzeski, global head of macro at ING.

"Given that the full impact of the tightening so far will still unfold in the coming months, the risk is even high that the ECB has already tightened too much." Germany's 10-year bond yield, the benchmark for the euro area, fell 7 basis points (bps) to 2.425% after briefly hitting 2.411%, its lowest in four months.

European Central Bank euro short-term rate (ESTR) forwards priced in a policy rate reduction of over 110 basis points (bps) in 2024 from around 95 bps the day before. They also discount an around 95% chance of a first 25 bps rate cut in April 2024.

The German economy is projected to grow by 0.6% in 2024 and 1.2% in 2025 but a budget crisis could lower growth, according to forecasts from the Organisation for Economic Cooperation and Development (OECD), which are less optimistic than those of the German government. Euro zone economic sentiment improved slightly for a second consecutive month in November.

Borrowing costs on both sides of the Atlantic have dropped as comments from central bank officials have failed to dislodge a market view policy rates will soon begin to fall. Sovereign bond yields fell on Tuesday after comments from Federal Reserve Governor Christopher Waller signalled a cut in interest rates may be on the horizon.

However, Bundesbank chief Joachim Nagel said the ECB may need to raise rates again if the inflation outlook worsens. Italy's 10-year government bond yield, the benchmark for the euro area's periphery, dropped 8 bps to 4.175%, close to a three-month low.

The spread between Italian and German 10-year yields – a gauge of the premium investors demand to hold debt of the euro area's most indebted countries – was at 174 bps. It hit 169.5 bps last week, its lowest since Sept. 21. There was a relatively muted reaction to remarks by ECB President Christine Lagarde, who hinted earlier this week at a possible earlier run-off of reinvestments from the Pandemic Emergency Purchase Programme (PEPP).

The central bank can use PEPP reinvestments to support bonds of the euro area's most indebted countries and to avoid fragmentation – an excessive yield spread widening which could hamper the transmission of monetary policy across the euro area.