Euro zone bonds dip on day, but set for best month in over a year

Euro zone bond yields rose on Thursday rebounding after recent declines, but were still on track for their biggest monthly drop in a year, as slowing inflation stokes bets that central banks will soon be cutting interest rates. Bonds have surged in November, and Germany's 10-year bond yield, the benchmark for the euro zone, has dropped 34 basis points this month, its biggest monthly drop since July 2022. Bond yields move inversely to prices.

The 10-year U.S. Treasury yield is set for its biggest monthly drop since 2008 - 55 basis points - and the Italian 10 year yield is set for a monthly drop of around 50 bps, its biggest since January 2020. Data on Thursday showed that euro zone inflation slowed to 2.4% year on year in November from 2.9% in October, well below expectations of a fall to 2.7%.

An index of euro government bonds has climbed 3.2% in November, in the biggest monthly rise in a year and a half. "Falling inflation and a stagnant economy could justify ECB cuts as soon as the first quarter of next year in our view," said Matthew Landon, global market strategist at JPMorgan Private Bank.

"Against that backdrop, European bonds continue to offer a compelling entry point even after the big rally we have seen over the last month." Thursday saw a small sell off in euro zone bonds with the German 10 year yield up 4 bps at 2.46%, edging off a four-month-low hit early in the session, and the Italian equivalent up 6 bps at 4.23%.

"I think bonds are correcting from stretched levels, nothing more in my view. US data was bond friendly," said Kenneth Broux a senior strategist at Societe Generale. Thursday's U.S. data, showed consumer spending rose moderately in October, while the annual increase in the PCE price index, a measure of inflation, was the smallest since early 2021.

Broux said markets were also watching the OPEC+ meeting, since "oil prices have been one of the driver of bonds since the summer". Delegates told Reuters that oil producers on Thursday agreed to output cuts approaching 2 million barrels per day for early next year.

MARKETS EXPECT APRIL RATE CUT Separate figures on Thursday showed that German unemployment rose in November and the French economy contracted in the third quarter, bolstering investors' bets that the European Central Bank will cut interest rates early next year.

Traders on Thursday moved to fully price in the first 25 bp interest rate cut in April, according to pricing in derivatives markets. They had previously seen a roughly 70% to 90% chance of such a move for most of November, after a drop in inflation in October. Germany's 2-year bond yield, which is sensitive to ECB interest rate expectations, was last flat on the day at 2.82%, around its lowest since early June.

"Policymakers won't want to declare victory prematurely and are sure to reiterate at December's ECB meeting that it is far too early to cut rates," said Andrew Kenningham, chief Europe economist at Capital Economics. "Nonetheless, with headline and core inflation likely to trend down in the new year it will be hard for the ECB to ignore the extent to which the inflationary tide is turning."