Euro zone bond yields edge back towards two-month lows

The spread between Germany and Italy, the benchmark for the European periphery, has also been narrowing and is not far from its narrowest since mid September at 177 bps. Italy's 10 year bond yield dipped 5bps to 4.40%, moving back towards a two-month low hit the previous day.

Euro zone bond yields edged lower on Thursday, resuming their broad downward trend driven by market expectations that central banks are done with raising interest rates, though the timing of rate cuts remains a topic of debate.

Germany's 10 year bond yield dipped one basis point to 2.62%, heading back towards a two-month low of 2.568% hit early the previous day. The Bund yield, the euro zone benchmark, has dropped fairly steadily since early October, when it briefly nudged above 3%, as economic data showed inflation was slowing in the United States and inflation and economic growth were slowing in Europe.

That, in turn, has underpinned the view that the recent programme of central bank rate increases around the world, which has weighed heavy on government bonds, has come to an end. The European five year/five year forward, a market-based gauge of euro zone inflation expectations, on Thursday was at its lowest level since April, with markets pricing roughly a 75% chance of a European Central Bank rate cut as soon as April next year.

The latest significant sign of slowing inflation was cooler-than forecast U.S. CPI data on Tuesday, the week's major macro economic release, after which the Bund yield dropped 11 bps and the U.S. 10 year Treasury yield fell nearly 20 bps. Yields ticked up a touch on Wednesday, a move analysts attributed partly to a sense that Tuesday's bond rally was slightly overdone, and to a data that showed a smaller than expected fall in U.S. retail sales.

"The European sovereign market is just trading based on whatever is happening with U.S. Treasuries, and we think the rally that happened on the back of the CPI numbers is unconvincing as it was provoked by markets expecting four U.S. rate cuts next year starting in June, or maybe May," said Althea Spinozzi, fixed income strategist at SaxoBank. She said strong U.S. economic data did not appear to match that many cuts and so soon.

"We believe that as we enter the new year there will be bigger divergence between European sovereigns and the U.S. because of the difference in the economic backdrop means we will see some easing in Europe before the U.S." Investors are also watching political developments after the German government on Wednesday froze major spending pledges focused on green initiatives and industry support after a constitutional court ruling on unused pandemic emergency funds blew a 60 billion euro ($65 billion) hole in its finances.

"This would imply slightly less (bond) issuance in 2024, but we think the market impact would be marginal," said Mohit Kumar chief economist Europe at Jefferies said in a note to clients. In Spain, acting premier Pedro Sanchez's party, the PSOE says Sanchez has enough support to win a Thursday parliamentary vote and establish a new term in office.

The spread between German and Spanish 10 year yields narrowed around 2 bps to 101.2 bps, just above the 96.6 it reached on Tuesday which was its narrowest since August. The spread between Germany and Italy, the benchmark for the European periphery, has also been narrowing and is not far from its narrowest since mid September at 177 bps.

Italy's 10 year bond yield dipped 5bps to 4.40%, moving back towards a two-month low hit the previous day. Germany's two-year yield fell 1 bp to 3.00% and Italy's dipped 3 bps to 3.66%.