Euro Zone Inflation Surge Shapes ECB's Rate Cut Decisions

German government bond yields rose to their highest in over six months as euro zone inflation hit 2.6% in May. This data influences the European Central Bank's rate cut plans, with markets expecting two cuts this year. The ECB's decisions and U.S. inflation data will shape future financial strategies.

German government bond yields rose to their highest in over six months on Friday, after data showed inflation in the currency bloc rose in May and ahead of U.S. inflation figures, both of which will shape central banks' rate cutting plans.

The higher-than expected euro zone inflation print of 2.6% year on year is highly unlikely to disrupt market's confidence in a European Central Bank rate cut next week, but casts doubt on the central bank's path after that. Markets are currently pricing around 57 bps of rate cuts in 2024, and are indicating a 25 basis point cut in June, and one more by year end. In recent weeks, they have been gradually paring back expectations of a third cut this year.

The German 10-year bond yield, the benchmark for the euro zone bloc, was last 4.6 basis points higher on the day at 2.7%, its highest since mid-November. Germany's two-year bond yield, which is more sensitive to European Central Bank rate expectations, was 4 bps higher at 3.12%, also an over six-month high.

The increase in the euro zone inflation rate to 2.6% in May was expected, and the data is "neither good nor bad," ECB governing council member Fabio Panetta

said on Friday." The data will nonetheless shape the narrative at the ECB's meeting on June 6. Recent communication from rate setters indicate a rate cut is all but certain, but they have given few indications for their plans after that.

"The expected ECB policy easing would likely provide short-term support to (European) rates, reducing the likelihood of further sell-off from the already high levels," said UBS analysts in a note. "But for European rates to rally significantly from this point, we would need to see more clarity on the ECB's rate-cutting cycle. The ECB appears less committal after June and it will continue to follow a data dependant stance, in our view."

U.S. PCE inflation for April, the Federal Reserve's preferred inflation gauge, is due at 1230 GMT. (0830 ET) That will shape expectations for when the Fed cuts rates, driving moves in U.S. Treasuries, and also have an effect on European rates.

The spread between U.S. 10-year Treasuries and German bunds widened 0.2 bps to 189 bps. Italy's 10-year yield was higher by 4.3 basis points​ at 4.00%, rising after the inflation data and the gap between Italian and German bunds widened 0.4 basis points to 129 bps.