European Bond Yields Drop as U.S. Inflation Slows

Euro zone government bond yields fell after unexpectedly low U.S. inflation data, pushing market speculation that the Federal Reserve might cut interest rates by September. Germany's and Italy's 10-year yields saw significant drops. Political uncertainty in France continues to affect bond markets as well.

Euro zone government bond yields dropped after cooler than expected U.S. inflation prompted markets to increase bets the Federal Reserve could cut interest rates as soon as September. U.S. consumer prices were unexpectedly unchanged in May month on month, and 3.3% higher year on year, both below analysts' expectations, leading markets to price in a roughly 70% chance of a Fed rate cut by September.

This pricing could be challenged, or underscored, by Fed chair Jerome Powell's press conference later on Wednesday, following the central bank's interest rate announcement. The Fed is likely to hold interest rates while publishing new economic projections likely showing fewer rate cuts this year than the three projected in March.

Germany's 10-year government bond yield, the benchmark for the euro area, was last down 8 basis points at 2.54%, on track for its biggest daily drop since May 15. Italy's 10 year yield dropped 12 basis points to 3.94% .

Even though the European Central Bank cut rates by 25 basis points last week, investors think its scope for substantial rate cuts while the Fed stays on hold is limited, so European assets are responsive to U.S. data. Money markets price just under 40 bps of ECB rate cuts by year-end, implying a second rate cut, likely in September or October, and around a 50% chance of a third move.

After the U.S. inflation data markets see 50 basis points of U.S. rate cuts this year. "While September may be on the table, today would have had to be the first of a handful of inflation data prints that went right, which it did," said Lindsay Rosner, head of multi-sector investing, Goldman Sachs Asset Management

"It does remain challenging, however for inflation to cool with the backdrop of the summer’s heat. Let's see what the Fed forecasts this afternoon. This is good news, but we will need more of it.” FRANCE FOCUS

French and Southern European borrowing costs remained under the spotlight after rising to their highest levels in around seven months on Tuesday. Markets fear 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. "The lack of policy clarity in the near term is likely to contribute to volatility in markets," said David Zahn, head of European fixed income at Franklin Templeton.

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 the upcoming legislative elections.

The spread between French and German bonds, a gauge of the risk premium investors demand to hold French bonds, was a fraction wider at 61.7 bps after hitting 66.9 the day before, its widest since March 2023. The French 10 year yield was down 7 bps after the U.S. data at 3.18%. It reached 3.338% on Tuesday, its highest since November.

The yield gap between Italian and German bonds tightened 5 bps to 140 bps. It hit 150.6 bps the day before, its widest since February.