Euro zone bonds steady, back in 'wait and see' mode after recent selloff

Germany's two-year yield was flat on the day at 2.60% and Italy's two-year yield rose 1 basis point to 3.25% . A $42 billion 10-year Treasury auction later on Wednesday could offer bond markets some direction.

Euro zone government bond yields held steady on Wednesday as traders assessed a bigger than expected fall in German industrial production in December and as borrowing costs on both sides of the Atlantic stabilised after recent sharp moves. Germany's 10-year yield, the benchmark for the euro zone, was a whisker lower at 2.29%.

The drop in German industrial production was the latest sign of weakness in the bloc's largest economy. Still, European Central Bank board member Isabel Schnabel said the ECB must be patient with cutting interest rates as inflation could flare up again. Neither German economic weakness nor the views of ECB hawks like Schnabel are new, but they illustrate the dilemma for rate setters as they decide when to begin interest rate cuts.

"We are in a bit of a wait-and-see mode right now. I believe that duration will likely range trade in the coming weeks as we need more of a catalyst to see a rally, but equally I don't see a massive sell off from here," said Emmanouil Karimalis, European rates strategist at UBS. 'Duration' conventionally refers to 10-year notes.

"This will depend on communication and data, given that all the central banks are in data dependent mode," Karimalis added. While conservatives or hawks in central bank-speak have pushed back on bets for an ECB rate cut in April, a move around mid-year appears uncontroversial.

Current market pricing indicates roughly a two thirds chance the ECB will begin cutting rates in April with a 25 basis point move. It shows a larger chance of 50 bps of cuts by June. Bond markets are currently very sensitive to changes in expectations of central banks' interest rate paths.

Yields in Europe rose sharply on Friday and again on Monday, tracking Treasuries after U.S. jobs data smartly beat expectations, causing markets to largely give up on expectations that the Federal Reserve will be cutting by March. The 18 basis point move in the German benchmark yield was its biggest two-day rise since March 2023.

Italy's 10-year yield was also little changed at 3.86% on Wednesday, leaving the closely watched spread between German and Italian 10-year yields at 155 bps. Germany's two-year yield was flat on the day at 2.60% and Italy's two-year yield rose 1 basis point to 3.25% .

A $42 billion 10-year Treasury auction later on Wednesday could offer bond markets some direction. An auction of new three-year notes on Tuesday saw solid demand. The U.S. has been raising the size of its auctions.

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