Euro zone yields hit multi-week lows, Italian-German spread briefly tightens

Euro zone government bond yields hit multi-week lows on Monday as markets priced in a higher chance of two rate cuts from the Federal Reserve in 2024 while fully discounting three moves by the European Central Bank.

Euro zone government bond yields hit multi-week lows on Monday as markets priced in a higher chance of two rate cuts from the Federal Reserve in 2024 while fully discounting three moves by the European Central Bank. Meanwhile, the spread between Italian and German 10-year yields briefly hit a fresh 1-1/2-month low as Fitch confirmed late on Friday a BBB rating on the Italian debt.

Germany's 10-year bond yield, the benchmark for the euro zone, fell 4 basis points (bps) to 2.45%, after reaching 2.439%, its lowest level since April 19. U.S. Treasury yields were flat, after tumbling to multi-week lows on Friday on news that the world's largest economy created fewer jobs than expected in April.

"We see a risk that a too-dovish Fed could lead to some (yield curve) steepening from here. The back end won't feel protected enough, while the front end could start settling on a September cut," said Padhraic Garvey, regional head of research Americas at ING, mentioning a likely spillover effect on Bunds. The German yield curve was still inverted but steepened on Friday with the gap between 10-year and 2-year German yields tightening to -43 bps after four straight widening sessions. It was at -44 bps on Monday.

Money markets price in 73 bps of ECB rate cuts in 2024 and 45 bps for the Fed, which implies one 25-bp cut and an 80% chance of an additional move. Italy's 10-year yield dropped 4 bps to 3.79%, after hitting 3.74%, its lowest since April 12.

The gap between Italian and German 10-year yields - a gauge of the risk premium investors ask to hold bonds of the euro area's most indebted countries - was at 131 bps after hitting 120.20 bps, its lowest since March 20. "European government bond spreads have room to tighten amid buoyant risk sentiment and the favourable flow pattern in May," said Rainer Guntermann, economist at Commerzbank.

"Rating risks remain contained with Fitch having just affirmed Italy and the market not fretting about Moody's review at the end of May after it raised the outlook to stable in November 2023," he added. Investors will closely watch the sale of BTP-Valore, which starts on Monday, as Italian small savers will likely rush to buy the new retail bond, taking advantage of the last opportunity to lock in higher returns before the ECB starts cutting interest rates. The central bank is growing more confident about cutting interest rates as euro zone inflation continues to ease, three ECB policymakers said on Monday.

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