Euro area government bond yields drop after UK data, await US figures

Euro zone inflation is heading back towards the 2% target but the European Central Bank needs more confirmation before it can cut rates, two influential policymakers said on Thursday. Germany's 10-year yield, the benchmark for the euro area, was down 3.5 basis points (bps) at 2.32%.

The euro area benchmark Bund yield fell from a 2-1/2 month high on Thursday ahead of U.S. economic data that could provide further clues about the Federal Reserve's monetary policy path. UK figures showed Britain's economy entered a recession in the second half of 2023, driving British yields down and affecting other fixed-income markets.

Analysts argued that euro area government bonds remained highly sensitive to economic figures as central banks were in "data-dependency mode". Euro zone inflation is heading back towards the 2% target but the European Central Bank needs more confirmation before it can cut rates, two influential policymakers said on Thursday.

Germany's 10-year yield, the benchmark for the euro area, was down 3.5 basis points (bps) at 2.32%. It hit 2.415% on Tuesday, its highest level since Dec. 1. It rose recently as rate-setters on both sides of the Atlantic warned that central banks must be cautious in easing monetary policy, leading investors to scale back bets on rate cuts in the euro zone in 2024 up to around 105 bps , from 145 bps at the end of January. It last discounted 115 bps.

The euro zone economy and inflation will grow slower than expected this year, the European Commission said on Thursday. A set of U.S. data, including retail sales and initial jobless claims, is due at 1330 GMT.

"U.S. econ team believes core retail sales will likely print above consensus expectations, underscoring a strong U.S. consumer," said Andrzej Szczepaniak European economist at Nomura. "This risks further retracement in both near-term Fed and ECB pricing of cuts." British 10-year yields dropped 7.5 bps to 3.98%.

Britain's gross domestic product (GDP) shrank by a worse-than-expected 0.3% in the three months to December, official data showed on Wednesday. "For the Monetary Policy Committee (MPC), this is a meaningful miss on GDP. There's clearly more spare capacity in the economy than assumed in their recent projections," said Sanjay Raja, UK economist at Deutsche Bank.

"While the Bank of England's focus will likely remain on price data, the bigger drop in output and the politics of being in a technical recession will no doubt become uncomfortable, especially with Bank Rate at highly restrictive levels." Japan also unexpectedly slipped into a recession at the end of last year.

Italy's 10-year yield, the benchmark for the euro area's periphery, dropped 4.5 bps to 3.82%, with the gap between Italian and German 10-year yields at 149 bps. Unicredit flagged that the BTP-Bund correlation has increased to 91% in the past three months, "signalling a smaller impact coming from Italy-specific factors."

"We think that Italian paper remains well supported in light of more appealing carry returns than on other euro zone curves," Unicredit said in a research note.