Euro Zone Bond Yields Drop Amid Weak Data and Falling Oil Prices

Euro zone government bond yields fell on Tuesday as weak economic data and declining oil prices led investors to bet on future ECB interest rate cuts. The German 10-year yield, a key benchmark, dropped significantly. Markets are anticipating U.S. jobs data, seeing U.S. trends influencing ECB policy expectations.

Euro zone government bond yields dropped on Tuesday as weak economic data and falling oil prices led investors to increase their bets on future European Central Bank interest rate cuts. Markets are awaiting U.S. jobs data later in the session after economic figures showed on Monday that U.S. manufacturing activity slowed for a second straight month in May, the latest indications that a gradual economic slowdown is taking hold.

The number of people out of work in Germany rose more than expected in May, data showed on Tuesday. "As central bankers wait for more clarity about the robustness and labour-intensity of the growth rebound, they may go slowly on the rate cuts," said Christian Schulz, deputy chief European economist at Citi, referring to German figures.

Oil prices eased as much as 1% on Tuesday, extending losses from a four-month low in the previous session. Germany's 10-year yield, the bloc's benchmark, was down 3.5 basis points (bps) at 2.55%, after dropping 6.5 bps the day before in its biggest daily fall since May 15.

"With just 35 bps discounted until year-end after this week's prospective ECB rate cut and falling oil prices reviving disinflation hopes, the momentum looks set to continue," said Christoph Rieger, head of rates strategy at Commerzbank. Investors are taking an ECB rate cut of 25 bps on Thursday for granted, but are uncertain about the outlook.

Money markets are pricing in about 63 bps of ECB monetary easing in 2024 - from less than 55 bps early on Monday - which implies two rate cuts and an around 50% chance of a third move by year-end. "Yet it seems markets are strongly driven by U.S. data when deciding on the number of ECB cuts to expect this year," rate strategists at ING said, after flagging that the correlation between U.S. Treasury and Bund yields is increasing again.

The spread between U.S. and German 10-year yields - a gauge of expectations for monetary policy divergence between the U.S. Federal Reserve and the ECB – hit a fresh 2-1/2-month low at 180.01 bps and was last at 183.8 bps, 3 bps wider from the day before. The gap between French and German 10-year government bond yields was still around 49 bps after Standard & Poor's cut its rating on France's sovereign debt late Friday, a move that market participants had widely expected.

Italy's 10-year yield fell 1.5 bps to 3.88% after dropping 9 bps, its biggest daily drop since May 15. "BTPs remain overall resilient though, defying more fundamental headwinds as the manufacturing PMI kept falling, taking the difference to Spain to a record high," Commerzbank's Rieger added.

Manufacturing activity contracted in Italy at the steepest pace this year, and grew at the fastest pace in more than two years in Spain. The yield gap between Italian and German bonds , a gauge of the risk premium investors seek to hold Italy's bonds, widened 2 bps to 132 bps.

Germany's 2-year yield, more sensitive to policy rate expectations, was down 2.5 bps at 3.01%.