Euro area yields hit 2-1/2 month low, markets price in 100 bps of rate cuts

ECB policymaker Robert Holzmann repeated on Friday that the central bank must stand ready to raise interest rates again if necessary, and said he did not expect the ECB to start cutting rates in the second quarter as some think it will. Italy's 10-year yield, the benchmark for the euro area's periphery, dropped 5 bps to 4.29%.

Euro zone long-dated yields hit fresh 2-1/2 month lows on Friday, and money markets increased their bets on European Central Bank rate cuts after soft U.S. data supported the view that the central banks' fight against inflation could be over. U.S. borrowing costs were lower in London trade, with 10-year Treasury yields hitting a fresh 2-month low, as recent data helped cement expectations the Federal Reserve will not raise rates.

For the euro area, money markets fully priced in 100 bps of rate cuts by December next year, including 50 bps by July 2024. They also discount an around 80% chance that the first 25 bps rate cut will be next April.

Germany's 10-year government bond yield, the benchmark for the euro area, dropped 4.5 bps to 2.54%, after hitting 2.517%, its lowest since Sept. 1. Bond yields move inversely to prices.

Some market participants were sceptical about a further fall in long-dated yields. "While being long interest rate duration risk (buying long-dated bonds) may, at first sight, appear to be a profitable business again, a more sober perspective, particularly on old-fashioned supply and demand dynamics, suggests otherwise", said Ralph Gasser, head of fixed income specialists at GAM.

"If we add that core inflation remains sticky and deflationary base effects of food and energy prices are already waning fast, breakevens, too, may be subject to upside surprises from here," he added, referring to the difference between nominal and real yields - a gauge of inflation expectations. Germany's 2-year yield -- most sensitive to short-term expectations for policy rates -- hit 2.90%, its lowest since June 7. It was last down 3 bps at 2.91%.

A key market gauge of euro area inflation expectations hit its lowest level since late March at 2.35%, in a further sign of confidence that central banks are winning their battle against unwanted consumer price dynamics. ECB policymaker Robert Holzmann repeated on Friday that the central bank must stand ready to raise interest rates again if necessary, and said he did not expect the ECB to start cutting rates in the second quarter as some think it will.

Italy's 10-year yield, the benchmark for the euro area's periphery, dropped 5 bps to 4.29%. It hit earlier in the session 4.254%, its lowest level since Sept. 4. The gap between Italian and German 10-year yields – a gauge of the risk premium investors ask to hold bonds of the euro area's most indebted countries – hit 172.40 bps, its tightest level since Sept. 21.

Moody's will review the sovereign credit rating of Italy late on Friday. The country is rated one notch above non-investment grade, with a negative outlook after the rating agency changed it from stable in August 2022. Most analysts expect Moody's not to change its rating and believe Italy will remain investment grade without a domestic political shock.

"There is a non-negligible probability that the outlook will be changed from negative to stable," UniCredit said in a research note. Spain's parliament voted to make Pedro Sanchez prime minister for another term on Thursday, ending a protracted deadlock after an inconclusive general election in July.

The spread between Spanish and German 10-year yields was at 99 bps after reaching Tuesday 96 bps, its tightest level since late August. It was at around 90 in June before the political deadlock.