Euro Zone Bonds Drop Amid Weak Factory Data and Anticipated ECB Rate Cut

Euro zone bond yields decreased as data revealed weak factory activity in both the euro zone and the U.S. Market anticipation for a European Central Bank rate cut on Thursday further influenced the bond market. Germany's 10-year bond yield fell 7 basis points to 2.577%.

Euro zone bond yields fell on Monday after data showed factory activity remained weak in the bloc and shrunk in the U.S. in May, as markets awaited a likely European Central Bank rate cut on Thursday. Germany's 10-year bond yield, the benchmark for the euro zone bloc, fell 7 basis points (bps) to 2.577%.

Final readings of survey-based gauges of Europe's manufacturing sector showed activity remained below the mark denoting growth for a 23rd month. The purchasing managers' index surveys also came in slightly lower than preliminary readings, although the downturn was still moderated compared to April.

"Overall, these data suggest that conditions in manufacturing remained difficult midway through Q2," said Claus Vistesen, chief euro zone economist at Pantheon Macroeconomics. "But they also clearly signal that the recession...is now easing."

U.S. manufacturing activity also slowed for a second straight month, the Institute for Supply Management's PMI survey showed, further supporting the idea that U.S. growth is set to slow as previous rate hikes bite. "Overall, the data is consistent with the view that the manufacturing sector is not going to add meaningfully to economic activity this year," said ING chief international economist James Knightley.

European bonds have often been driven by expectations for Federal Reserve policy over the last two years, given the size and importance of the U.S. economy. Markets were not fully pricing the first quarter-point rate cut from the Fed until November, with around a two-in-three chance they move in September.

Italy's 10-year yield was down 7.5 bps at 3.887%, and the gap between Italian and German yields stood at 130 bps. The market's focus this week is on the ECB's interest rate decision on Thursday, when it is all but certain to cut rates to 3.75%, from the current record high of 4%.

Investors will be looking out for any hints about when the next reduction might come, with some on the ECB's Governing Council pushing back against the idea of a July cut. Data last week showed that euro zone inflation was stronger than expected in May. Germany's two-year bond yield, which is more sensitive to European Central Bank rate expectations, was down 5 bps at 3.033%.

"While there is a consensus on this first rate cut, the pace of future cuts is already subject to lively debate within the Council," said Franck Dixmier, global chief investment officer for fixed income at Allianz Global Investors, in emailed comments. "Future inflation data is likely to be volatile, and the ECB is likely to caution that it is sticking to its gradual approach to cutting rates."

French bonds showed little notable reaction to ratings agency S&P downgrading the country's credit rating late on Friday. Just before the EU's parliamentary elections, S&P cut France's rating to "AA-" from "AA", saying higher than expected deficits would push up debt in the euro zone's second-biggest economy.

France's 10-year bond yield was down 7 bps at 3.0668%, broadly in line with the move in other euro zone country bonds.