Euro zone yields fall after Powell comments, await ECB meeting

The Bank of England raised rates to 4% on Thursday but dropped its pledge to keep increasing them "forcefully" if needed and said inflation had probably peaked. Italy's 10-year government bond yield dropped 6.5 bps to 4.23%.

Euro zone government bond yields fell on Thursday as investors braced for the European Central Bank policy meeting after remarks from Federal Reserve Chair Jerome Powell cemented expectations that the U.S. tightening cycle might end soon. The Fed said on Wednesday it had turned a critical corner in the fight against high inflation after announcing an expected 25 basis point (bp) interest rate hike and projecting further rate increases.

Some analysts said that the European Central Bank (ECB) would need to be hawkish at its meeting later in the day to avoid sparking a bond rally. That would mean president Christine Lagarde focusing more on work to be done than progress made. Markets await ECB guidance and detailed parameters for reducing its bond holdings, while a 50 bps increase in policy rates is widely expected.

Germany's 10-year yield fell 3.5 bps to 2.26%. "With no clear signs of a peak in core inflation yet and a tight labour market, any softening of rhetoric appears very unlikely for now," UniCredit analysts said in a research note.

The U.S. 10-year Treasury yield was up 2 bps at 3.42%, after falling as much as 13 bps on Wednesday following the Fed meeting. The spread between U.S. and German 10-year yields was at 116 bps after dropping to its tightest since September 2020 at 110.6 bps in Asian trading.

The likely divergence between the ECB and the Fed tightening cycles might trigger a further narrowing of the U.S.-German yield spread as policy rates are expected to rise more in the euro area than in the United States. The Bank of England raised rates to 4% on Thursday but dropped its pledge to keep increasing them "forcefully" if needed and said inflation had probably peaked.

Italy's 10-year government bond yield dropped 6.5 bps to 4.23%. The closely watched spread between Italian and German yields - a gauge of the risk premium for the government bonds of Southern Europe's highly indebted countries – was at 195 bps. It hit its widest since Jan. 4 at 205 bps on Monday.