Euro zone bond yields struggle for direction ahead of U.S. data

ECB chief economist Philip Lane, who is seen as a policy dove, said on Monday euro zone inflation would slow sharply this year but price growth momentum remains high for now, including for underlying goods and services. "The ECB plans to hike more than once, and an eventual pause is more likely alongside fresh staff projections in September rather than in July," Aman Bansal, European rate strategist at Citi, said in a research note.

Euro zone government bond yields struggled for direction on Tuesday ahead of U.S. inflation data that will provide fresh clues about the Federal Reserve's policy path, affecting market bets on the European Central Bank's future moves. Fed chair Jerome Powell said last week that policy decisions would be "driven by incoming data" while signalling a likely pause in the rate hiking cycle.

Current analyst estimates on ECB hikes involve balanced risks around a 3.5%-4.0% terminal rate, but the health of the U.S. economy will be one of the critical factors in deciding the exact landing point. The harder a recession in the U.S. is, the harder it will be for the ECB to raise rates, some analysts argued.

According to the Fed's Senior Loan Officer Opinion Survey, U.S. banks tightened credit standards over the first months of the year, indicating that higher rates were starting to bite. Germany's 10-year government bond yield, the bloc's benchmark, was down one basis point to 2.31%.

The German 2-year yield, more sensitive to expectations for policy rates, dropped 0.5 bps to 2.65%. Analyst views about the ECB decisions were still mixed, with some doubting that the hawks will be able to push market rates materially higher, given that developments in the U.S. largely dictate economic sentiment.

Others more focused on inflation risks reckoned financial markets are currently under-pricing the ECB policy path. ECB chief economist Philip Lane, who is seen as a policy dove, said on Monday euro zone inflation would slow sharply this year but price growth momentum remains high for now, including for underlying goods and services.

"The ECB plans to hike more than once, and an eventual pause is more likely alongside fresh staff projections in September rather than in July," Aman Bansal, European rate strategist at Citi, said in a research note. "The front-end looks too rich in this context in our view, especially given the strength of inflation momentum," he added.

ECB's Peter Kazimir - seen as a hawk - said on Tuesday the central bank might need to raise rates for longer than currently anticipated, and September could be the earliest moment when policymakers could judge whether rate hikes have been effective. The September ECB euro short-term rate (ESTR) forward was at 3.58%, implying market expectations for the ECB deposit facility rate to peak at around 3.68%. The deposit rate is currently at 3.25%.

"Immediately after the ECB, we recommended paying July ECB ESTR as we expect the market to move back towards fully pricing 25bp hikes in June and July," Citi's Bansal argued. Italy's 10-year bond yield was flat at 4.24%, with the spread between Italian and German 10-year yields - a gauge of investor sentiment towards the euro area's most indebted countries - widening to 192 bps.