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

Euro zone government bond yields dropped for the second day as weak economic data and falling oil prices led investors to bet on future European Central Bank rate cuts. Significant unemployment in Germany and a slowdown in U.S. job openings have influenced the market, with uncertainty around future ECB rate cuts.

Euro zone government bond yields dropped for a second day on Tuesday as weak economic data and falling oil prices led investors to increase their bets on future European Central Bank interest rate cuts. The number of people out of work in Germany rose more than expected in May, data showed on Tuesday, while oil prices eased as much as 1%, extending losses from a four-month low hit the previous session.

The bond rally accelerated later in the session after data showed U.S. job openings fell more than expected in April to the lowest in more than three years. This was a second set of data from the U.S. suggesting that a gradual economic slowdown is taking hold after Monday's soft manufacturing activity numbers. Germany's 10-year yield, the bloc's benchmark, dropped 6 basis points (bps) to 2.53%. It had fallen 6.5 bps the day before, its biggest daily fall since May 15, leaving it on track for its biggest two-session fall since early January.

"The momentum looks set to continue," said Christoph Rieger, head of rates strategy at Commerzbank, pointing to "falling oil prices reviving disinflation hopes", and the fact that markets are not pricing in substantial ECB rate cuts after June. Investors are taking an ECB rate cut of 25 bps on Thursday for granted, but are uncertain about the outlook after that, with money markets pricing in about 63 bps of ECB monetary easing in 2024 - from less than 55 bps early on Monday.

That implies two rate cuts and a roughly 50% chance of a third move by year-end. CAUTION

Policy makers are still likely to be cautious however. "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, commenting in the context of the German unemployment figures.

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 181.4 bps, 3 bps wider from the day before. Investors in April had been pricing in expectations that ECB policy might meaningfully differ from the Fed's, though this has since eased.

"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. 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 2 bps to 3.87% after dropping 9 bps the day before, its biggest daily decline since May 15. "(Italian) BTPs remain overall resilient, defying more fundamental headwinds," Commerzbank's Rieger added.

Manufacturing activity contracted in Italy at the steepest pace this year. 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 4 bps at 2.99%.