German Bond Yields Peak Amid Economic Data and Cautious ECB Rate Cut Bets

German 2-year bond yields hit six-month highs as upbeat eurozone data and British inflation figures led investors to scale back ECB rate cut bets to 60 basis points in 2024. Analysts foresee gradual rate cuts while the eurozone economy shows recovery signs. Italy's yields also saw minor changes.

German 2-year bond yields hit their highest in six months on Thursday as economic data from the euro area and Britain led investors to scale back their bets on future European Central Bank (ECB) rate cuts to 60 basis points in 2024. The 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 Britain 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 around 60 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 British inflation data.

Analysts take for granted an ECB move in June, but also highlight that markets have started pricing in less than the cut every quarter thereafter which had been implied by derivatives in the last few months. "The market repricing since April had already taken out much of the probability for cuts at 'in between' meetings, but it is now starting to challenge quarterly cuts, with around 65 bp priced to year-end," said analysts at Citi in a research note.

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% after hitting on Wednesday 2.556%, its highest level since May 2.

"Today's purchasing managers' indices support our call for a continuing economic recovery in the Eurozone," said Salomon Fiedler, economist at Berenberg, adding softer input and output inflation supports expectations for a rate cut in June. He forecasts gross domestic product to expand by 0.2% in the second quarter, before accelerating further.

Italy's 10-year yield rose 0.5 bps to 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.