Euro Zone Bond Yields Surge as Investors Scale Back ECB Rate Cut Expectations

German 2-year bond yields reached a six-month high as better-than-expected economic data from the euro zone and Britain led investors to lower their ECB rate cut projections for 2024. The euro zone PMI rose to 52.3, suggesting ongoing economic recovery, but future rate cuts may be slower than anticipated.

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 mid November, last up 9 basis points (bps) at 3.10%.

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," Citi analysts said 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 7.3 bps to 2.60% after hitting its highest level since late April.

"Today's purchasing managers' indices support our call for a continuing economic recovery in the euro zone," 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 7.6 bps to 3.90%, touching its highest in more than a week. 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 – stood at 129 bps.

European Commission figures released on Thursday also showed euro zone consumer confidence improved to -14.3 this month from -14.7 in April. Economists polled by Reuters had expected a rise to -14.2.

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