Euro Zone Bond Yields Surge Amid Strong Economic Data

Euro zone bond yields are set for their largest weekly rise in a month due to robust economic data. Germany's 10-year bond yield, a key benchmark, hit its highest point since April. Strong demand in services and a recovering manufacturing sector drive this increase, pushing back expectations for central bank rate cuts.

Euro zone bond yields were on track for their biggest weekly rise in a month on Friday, although they were little changed on the day, after strong economic data caused traders to further scale back their bets on central bank interest rate cuts. Germany's 10-year bond yield, the benchmark for the euro zone bloc, was down 1.5 basis points (bps) at 2.59% after hitting 2.618%, its highest since April 26.

The yield, which moves inversely to the price, was heading for a 7.5 bps rise across the week. A survey-based gauge of the economy on Thursday showed euro zone business activity expanded at its fastest pace in a year this month, supported by buoyant demand for services, while the manufacturing sector showed signs of recovery.

Separate data showed euro zone wage growth remained strong and U.S. survey numbers pointed to continued strength in the American economy. The readings convinced traders that the world's central banks are less likely to lower interest rates this year. They now price in 57 bps of European Central Bank rate cuts in 2024 - which implies two 25 bps move and an around 30% chance of a third cut - down from closer to 75 bps in mid-May.

Analysts highlight that markets have started discounting less than a cut every quarter, a move which rate derivatives have priced in for months. Bundesbank President Joachim Nagel on Friday said a rate move by the ECB in June was more likely if price development remains stable.

"Yesterday's data was another reminder that the timing for a full-blown global easing cycle is still a long shot," said Michiel Tukker, senior European rates strategist at ING. "The pricing for European Central Bank cuts in 2024 is down to 60 bp (and) could go even lower in our view. For the U.S., the case for higher yields based on the latest figures is even stronger."

Germany's 2-year yield, which is sensitive to ECB rate expectations, was flat at 3.08% on Friday, after hitting 3.124%, its highest level since November. The spread between U.S. 10-year Treasuries and German bunds - a gauge of the expected policy path divergence between the ECB and the Fed - tightened slightly to 188 bps. It reached 220 bps in mid-April.

"We should not expect the Fed to cut any time soon while the start of the easing cycle for the ECB looks around the corner," said BofA's economist Claudio Irigoyen, adding its forecasts included the recent inflation prints and the output gaps. According to BofA, the spread between U.S and German yields can break recent peaks by year-end.

Next week investors will be looking closely at U.S. personal consumption index inflation - the Federal Reserve's preferred measure - and headline euro zone consumer price index figures. Italy's 10-year yield was down 0.5 bps at 3.89% on Friday and was set for a weekly rise of 8.5 bps.