Euro Zone Yields Drop Amid U.S. Inflation Data Anticipation

Euro zone yields declined as investor focus shifted to U.S. inflation data and a Federal Reserve policy decision. The Fed is expected to keep interest rates unchanged, with projections indicating fewer rate cuts. German 10-year bond yields dropped, while political uncertainty in France impacted bonds after a snap vote announcement.

Euro zone yields dropped on Wednesday as investors' focus shifted to key U.S. inflation data and a Federal Reserve policy decision later in the session.

The Fed is expected to leave interest rates unchanged on Wednesday, with new economic projections from the U.S. central bank's policymakers likely to show fewer rate cuts this year and a delayed start to monetary policy easing. Germany's 10-year government bond yield, the benchmark for the euro area, was down 1.5 basis points (bps) at 2.61% on Wednesday. It hit 2.707% at the end of May, its highest level since mid-November.

Investors expect the U.S. data to remain in the driver’s seat for euro area rates. "Even if the (U.S.) consumer price index comes in as expected, we still think the annualised figure is not one that should appease bond markets," said Padhraic Garvey, regional head of research Americas at ING, adding that he maintains an upward bias on U.S. Treasury yields.

"The Fed needs at least a series of 0.2% month-on-month inflation readings to move forward with rate cuts," he argued. Money markets discount a bit less than 40 bps of European Central Bank rate cuts by year-end, implying a second rate cut and an around 50% chance of a third move. . They also priced in 40 bps of Fed cuts.

Henk Potts, market strategist at Barclays private bank, said he expected just one 25 bps cut by the Fed this year. French and Southern European borrowing costs were still under the spotlight after rising to their highest levels in around seven months on Tuesday.

Markets feared that gains by eurosceptics in Sunday's European Parliament elections and the announcement of a snap vote in France could complicate European Union attempts to deepen integration. Such a backdrop would increase the premium investors demand to hold bonds of highly indebted countries.

Political uncertainty and risks of worsening long-term fiscal sustainability if the far-right should win the next elections further weighed on French assets. French President Emmanuel Macron on Wednesday urged rival parties on both sides of the political centre to join him in forging a democratic alliance against Marine Le Pen's far-right National Rally (RN) in upcoming snap legislative elections.

The spread between French and German bonds, a gauge of the risk premium investors demand to hold French bonds, was flat at 61.5 bps after hitting 66.9 the day before, its widest since March 2023. Italy's 10-year yield fell 2.5 bps to 4.04%.

The yield gap between Italian and German bonds tightened 2.5 bps to 142.50 bps. It hit 150.6 bps the day before, its widest since February.