Yields and Data Drive European Economic Outlook

German two-year yield hit its lowest since February as weak economic data heightened expectations for a quicker ECB monetary easing. U.S. economic data suggested strong growth but subsiding inflation, leading to forecasts of a September interest rate cut from the Federal Reserve. The euro area, however, showed signs of economic slowdown.

German two-year yield hit its lowest since February and the yield curve reached its least inverted level in six months on Thursday as weak economic data led investors to increase bets on a quicker European Central Bank monetary easing cycle. Euro area borrowing costs pared their early fall after U.S. data showed the economy grew faster than expected, but inflation subsided, supporting expectations for a September interest rate cut from the Federal Reserve.

Thursday’s U.S. data "will quiet some voices calling for a cut as early as next week," said Colin Finlayson, investment manager at Aegon Asset Management. Data from the bloc showed a less rosy picture, with the German Ifo Institute saying its business climate index fell to 87.0 in July from 88.6 in June, compared with a reading of 88.9 forecast by analysts in a Reuters poll.

A survey showed on Wednesday that euro zone business activity stalled in July. German short-dated bond yields dropped recently while the long-dated recorded just a slight fall, bringing the yield curve to its least inverted level in six months.

Germany's two-year yield, sensitive to policy rate expectations, was down 2.5 basis points (bps) at 2.69%, after hitting 2.365%, its lowest since early February. It has fallen around 15 bps in the last three trading sessions in the wake of weak economic data from both sides of the Atlantic.

The euro zone benchmark 10-year Bund yield dropped one bp to 2.43%. The spread between the two rose to -25.5 bps after reaching earlier in the session -23.3 bps, its least inverted since January. Money markets fully priced in 50 bps of ECB rate cuts and a less than 10% chance of a third easing move by year-end. They expect the easing cycle to end around summer 2025 with an ECB deposit facility rate of about 2.5%, roughly unchanged from the previous days' expectations.

The ECB deposit rate is now at 3.75%. "Unfortunately for the ECB, the Ifo survey is less clearly deflationary than the PMIs yesterday," said Christian Schulz, deputy chief European economist at Citi.

"Hiring intentions fell sharply in the services sector and were steady in manufacturing, suggesting further easing in the labour market," he added. "However, price expectations actually rose marginally in the downstream services and retail trade industries."

Meanwhile, the premium investors demand to hold French bonds rather than German Bunds was at 70 bps. It rose to 71.70 bps, the highest since France's inconclusive election earlier this month, after the far-left La France Insoumise's (LFI) proposal to reverse President Emmanuel Macron's pension reform with support from the far-right Rassemblement National (RN).