Euro Zone Bonds Rise as Investors Adjust ECB Rate Cut Bets

Euro zone bond yields surged, with German 2-year yields hitting a 6-month high after upbeat economic data and inflation figures from the UK. HCOB's PMI indicated continued economic expansion, causing investors to reassess European Central Bank rate cut expectations. The ECB remains cautious amid mixed signals.

Euro zone government bond yields rose Thursday, with German 2-year yields hitting their highest in six months after economic data from the bloc and the UK led investors to scale back their bets on future European Central Bank rate cuts. HCOB's preliminary composite Purchasing Managers' Index (PMI) for the euro zone climbed to 52.3 this month from April's 51.7, beating expectations in a Reuters poll for a more modest lift to 52.0.

Negotiated pay growth in the euro zone picked up slightly in the first quarter of 2024, ECB figures showed, bolstering the case for caution in cutting interest rates from record highs. Germany's 2-year yield, more sensitive to policy rate expectations, hit its highest since November at 3.057% and was last up 3 basis points (bps) at 3.04%.

Wednesday's inflation figures from the UK led investors to discount less than 65 bps of ECB rate cuts in 2024 for the first time this year, driving yields to multi-week highs. Money markets last priced 60 basis points (bps) of ECB rate cuts in 2024 - which implies two 25 bps moves and a less than 50% chance of a third cut this year - from 67 bps on Wednesday before the UK inflation data.

Meanwhile, Federal Reserve minutes were seen as hawkish as policymakers acknowledged disappointment over recent inflation readings at their last meeting. "The PMIs for May suggest that the euro zone economy continued to expand in Q2 while price pressures eased but remained high in the services sector," said Franziska Palmas, senior Europe economist at Capital Economics.

"The ECB is still very likely to go ahead with a rate cut in June, but if the economy continues to hold up well, cuts further ahead may be slower than we had anticipated," she added. Germany's 10-year yield, the bloc's benchmark, rose 1 bp to 2.54%.

"The dynamism in manufacturing fits with the view that external demand is currently leading the positive momentum in the euro area," said Mark Wall, chief European economist at Deutsche Bank. "Employment is slow, consistent with a cyclical rebound in productivity. Margins are compressing. So the bigger picture is one of normalization," he added.

Italy's 10-year yield was flat at 3.83%. The gap between Italian and German 10-year bond yields -- a gauge of the risk premium investors seek to hold bonds of the euro area's most indebted countries – tightened slightly to 128 bps.

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