Euro zone yields rise, markets trim bets on 2024 ECB rate cuts

Germany's 2-year yield, more sensitive to policy rate expectations, also hit a two-week high, rising 4 basis points (bps) to 2.66%. ECB euro-short-term rate (ESTR) forwards priced in 120 basis points (bps) of rate cuts in 2024, compared to around 130 bps late Wednesday, implying a fall in the deposit facility rate to 2.80% by the end of the year from 4% now.

Euro zone government bond yields rose to a two-week high on Thursday and markets scaled back bets on future rate cuts after policymakers on both sides of the Atlantic reiterated that central banks must be cautious on easing monetary policy. European Central Bank (ECB) policymaker Pierre Wunsch said the bank should wait for more wage data before cutting interest rates. His colleague, ECB board member Isabel Schnabel, also argued the ECB must be patient.

In the U.S., Federal Reserve officials said they wanted to hold off on cutting interest rates until they have more confidence that inflation is down to 2%. Germany's 10-year government bond yield, the benchmark for the euro area, rose 5 basis points (bps) to 2.35%, hitting a two-week high.

Similarly, Italy's 10-year government bond yield rose to a two-week high, up 5 bps to 3.93%. Germany's 2-year yield, more sensitive to policy rate expectations, also hit a two-week high, rising 4 basis points (bps) to 2.66%.

ECB euro-short-term rate (ESTR) forwards priced in 120 basis points (bps) of rate cuts in 2024, compared to around 130 bps late Wednesday, implying a fall in the deposit facility rate to 2.80% by the end of the year from 4% now. The ESTR is around 10 bps above the deposit rate. "In the absence of new bank jitters (in the U.S.), the Bund yield is well supported above 2.30%, a level that is in line with new ECB estimates about the natural rate of interest (r*)," said Christoph Rieger, head of rate research at Commerzbank.

Shares in New York Community Bancorp closed higher on Wednesday after the lender said it could cut exposure to the troubled commercial real estate (CRE) segment. Concerns about a possible crisis would lead central banks to cut rates faster to ease pressure on troubled banks.

"It’s clear that markets are still pricing in a risk that they may end up needing to move quicker than that," Deutsche Bank said in a research note, after mentioning concerns about U.S. regional banks. Markets are pricing in a 20% chance of a Fed rate cut in March, according to the CME Group's FedWatch Tool.

The "neutral" or "natural" interest rate known as "r*" is one that neither stimulates nor slows economic growth, and is where policy rates are supposed to end up. Analysts mentioned a recent ECB paper saying that "estimates of euro area r* vary widely across a suite of models; the median estimate has risen by about 30 basis points compared with levels prevailing in mid-2019, before the onset of the pandemic."

"The euro area real r* was seen to be at levels around or below zero after the global financial crisis," argued Commerzbank's Rieger. "Taking zero + 30 bps, +2% inflation would imply 2.3%, which is also close to longer-term forwards." Citi economists highlighted that the ECB paper said the increase in the median estimate was driven by "cyclical, inflation-stabilising r* estimates" while the longer-term r* was unchanged.