Euro zone bond prices rally for longest stretch since February

Euro zone government bond prices rose for a fifth consecutive day, driven by falling oil prices and cooling inflation expectations, as yields tumbled and stocks soared.

Euro zone government bond prices rose for a fifth day on Tuesday, in their longest rally since February, as cooling market expectations for inflation met caution ahead of Kevin Warsh's first meeting as head of ‌the Federal Reserve.

The oil price has fallen to below $80 a barrel, a drop of 10% since Monday after the United States and Iran said they had reached an agreement on the framework for a peace deal, to be signed in Geneva on Friday. As a result, bond yields - which move inversely to prices - have tumbled and stocks have soared ‌along with rate-sensitive assets like gold.

Benchmark German 10-year yields fell 1.6 basis points to 2.9242%, as prices rose for the longest since mid-February, prior to the start ‌of the Iran war. Yields are still nearly 30 bps higher than in late February, but have pulled back sharply from last month's 15-year highs near 3.2%.

Two-year yields, which tend to react more to shifts in expectations for inflation and rates, have retreated more slowly. Two-year Schatz yields - which on Wednesday were down 1.3 bps at 2.5715% - are more than 55 bps higher than on the eve of the ⁠war on ​February 27. ONE MORE ECB HIKE EXPECTED

Investors expect ⁠one more rate hike from the European Central Bank this year, after last Thursday's quarter-point increase. A week ago, a total of three hikes were priced in for 2026, which most market watchers believed ⁠would have been excessive. ECB chief economist Philip Lane said in an interview at the Reuters NEXT Europe conference in London on Tuesday that the central bank would remain "proactive" in its fight ​against high inflation.

Deutsche Bank strategist Jim Reid noted the ECB's continued concerns. "So even with oil prices coming down again, markets are still fully pricing in a ⁠second ECB hike before the end of the year, following on from last week's move," he said.

Euro zone inflation rose 0.1% month-on-month in May, in line with expectations, data from Eurostat showed on Tuesday. ⁠Annual inflation ​held steady at 3.2%, matching a Reuters poll. Core inflation, which excludes energy, food, alcohol and tobacco, came in at 2.6% year-on-year, slightly above forecasts of 2.5%.

"Despite last week's hawkish shift in the ECB policy, the government bonds have been rallying and yields falling as cheapening oil prices ease inflation expectations and softening future ECB prospects," ⁠said Ipek Ozkardeskaya, senior market analyst at Swissquote Bank. "If the Middle East war ends and energy prices decline sustainably, the ECB could discard another rate hike - and depending ⁠on euro area economies' reaction, could even ⁠be brought to walk back the latest step," she added.

If oil prices remain low for an extended period, interest rates are likely to stay low as well — a dynamic favourable for bonds, Ozkardeskaya said. Italian 10-year yields were down 1.3 bps ‌on the day at 3.6377%, which ‌kept their premium over German Bund yields just below 70 bps.