Euro Zone Government Bond Yields Rise Amid U.S. Data Anticipation

Euro zone government bond yields rose after a week of declines as investors awaited significant U.S. economic data. Short-term German borrowing costs marked their largest weekly drop since June, influenced by soft economic data on both sides of the Atlantic. Analysts expect U.S. PCE data to influence future ECB rate cuts.

On Friday, Euro zone government bond yields edged higher following a week of declines, influenced by anticipation of critical U.S. economic data. Short-dated German borrowings witnessed their most significant weekly drop since mid-June, driven by weak economic indicators from both Europe and the U.S., prompting expectations of swifter easing by the European Central Bank.

Money markets are currently pricing in two 25 bps ECB rate cuts and a 10% probability of a third in 2024, up from under 70% of two rate cuts at the start of the week. This comes after surveys indicated a surprising dip in German business morale and stagnation in euro zone business activity growth.

Analysts suggest that the decline in risky assets redirected some safe-haven flows into fixed income. This increased bond prices and reduced yields. Germany's two-year government bond yields rose one basis point to 2.69%, setting the stage for a 9 bps weekly drop, the largest since mid-June.

In June, euro zone consumers halted their decline in inflation expectations after four consecutive monthly drops, according to an ECB survey. Germany's 10-year yield, the euro area's benchmark, increased by 2 bps to 2.36%, aiming for an unchanged weekly close.

Investors are primarily focused on the U.S. personal consumer expenditure (PCE) data, anticipating a brief market reaction to stronger figures as the Federal Reserve might move towards a rate cut in September. Paul Donovan, UBS Wealth Management's chief economist, highlighted the strength of U.S. consumer spending as per recent GDP data.

Euro area yields trimmed their initial decline on Thursday after U.S. economic growth outpaced expectations. According to UBS' Donovan, the broad PCE deflator is less affected by technical measures and disinflation is expected to continue.

The yield spread between French bonds and German Bunds tightened to 69 bps, having reached 71.70 bps earlier this week—the highest since France's recent election—due to political uncertainties related to pension reform.

Commerzbank strategist Rainer Guntermann noted that euro zone government bond spreads are now more closely aligned with overall risk sentiment rather than ECB rate cut expectations alone.