German bond yields fall but set for biggest weekly rise in over a month

Eurozone bond yields fell on Friday, with Germany's two-year bond yield dropping 1 basis point to 2.64%, despite being up around 10 basis points on the week.

Euro ​zone bond yields fell on Friday as oil prices retreated and investors ​judged the latest flareup in the Iran conflict was ‌unlikely ​to escalate, although it left German yields on track for their biggest weekly rise in more than a month. Germany's two-year bond yield, which is sensitive to European Central Bank interest rate expectations, fell 1 basis point to 2.64% but ‌was still up around 10 basis points on the week, marking its largest weekly increase in five weeks.

The benchmark 10-year Bund yield dropped 2 bps to 3.03%, after touching a more than one-month high of 3.09% on Thursday. It was also up roughly 10 basis points this week, on course for its biggest rise since ‌early May. Earlier this week, renewed U.S.-Iran tensions prompted traders to increase bets that the ECB could deliver two additional rate hikes this year following its June ‌move, pushing bond yields higher.

By Friday, however, markets stabilised as Brent crude slipped to around $75 a barrel having briefly climbed above $80 earlier in the week. A U.S. official said Washington remained committed to finding a resolution with Iran and that "technical talks continue". Money markets were pricing in around 32 basis points of ECB tightening by year-end on Friday, implying one further quarter-point rate increase and roughly a ⁠30% chance ​of a second move. That was down from ⁠about 36 basis points earlier in the week.

But while the week's move was partly a response to higher energy prices and inflation expectations, that was not the only thing in the mix, ⁠particularly for longer dated bonds, said Lale Akoner, global market strategist at eToro. "While geopolitical tensions have pushed inflation concerns back into focus, the bigger story is that investors are demanding greater ​compensation to hold long-term government debt," she said.

"Improving euro zone economic data has also reduced expectations for easier monetary policy, adding further pressure on bonds." European ⁠bonds on Friday also found support from a rally in Japanese government debt after reports that Tokyo was exploring ways to encourage pension funds to increase allocations to domestic assets. Commerzbank analysts warned such ⁠a ​move could become a risk for global bond markets if Japanese investors repatriate funds from abroad.

Japan's finance minister said the government aimed to steer the country's vast public pension funds towards substantially greater investment in domestic assets, boosting the yen and Japanese bonds. The benchmark 10-year Japanese government bond yield fell 11.5 basis points ⁠to 2.760%, its steepest daily decline in more than a year.

Akoner said any shift in Japanese pension fund allocations could have broader implications for global markets. "Japan has ⁠long been one of the largest ⁠sources of demand for overseas bonds, particularly U.S. Treasuries. Even a modest shift toward Japanese government bonds could support the yen and reduce a reliable source of foreign demand for U.S. debt," Akoner added.

"Structural changes in who buys government bonds ‌can have a much bigger ‌impact on markets than short-term policy headlines."