Euro zone bond prices rally for longest stretch since February

Euro zone government bond prices rose for a fifth consecutive day, driven by cooling inflation expectations and a decline in oil prices, causing bond yields to tumble and stocks to soar.

Euro zone ‌government ​bond prices rose for a fifth day on Wednesday 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 below $80 a barrel since 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 fall when prices rise - have tumbled and stocks have soared along with rate-sensitive assets like gold. Benchmark German 10-year yields fell 1 basis point to 2.9295% 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 high 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 flat at 2.5853% - 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 1.6 bps on the day at 3.6383%, which kept their premium over German Bund yields just below 70 bps.

LOOKING AHEAD TO WARSH With data showing strong U.S. hiring, a relatively low 4.3% unemployment rate, and inflation well above the U.S. central bank's 2% target, many ⁠analysts anticipate the Fed will hold rates steady on Wednesday. They also expect it to remove language from its policy statement about "additional adjustments" to its benchmark interest rate. The reference has been used to ⁠indicate likely future decreases in borrowing costs. "Attention will rest squarely ⁠on Chair Warsh’s debut press conference," said JPMorgan analysts Jay Barry and Jason Hunter. "There is a high degree of uncertainty surrounding his communications given his brief media appearances thus far, the recent hawkish shift in the Committee, and his own views on reducing forward guidance."

"We think it is possible the Committee ‌under Warsh trims the policy statement further, ‌but we doubt this will be done at Warsh’s inaugural meeting."