Euro zone yields jump as markets price in slight chance of further hike

Germany's policy-sensitive 2-year bond yields were on track on Friday for their biggest weekly rise since mid-June following the European Central Bank's (ECB) 25 basis point rate hike the previous day. They are now pricing a roughly 30% chance of a tightening move by December from around 20% the day before. Germany's 10-year government bond yield, the benchmark for the euro area, was up 8 bps at 2.671%.

Germany's policy-sensitive 2-year bond yields were on track on Friday for their biggest weekly rise since mid-June following the European Central Bank's (ECB) 25 basis point rate hike the previous day. The ECB raised its key interest rate to a record high of 4% on Thursday but signalled the hike would likely be its last, stressing the central bank will be data-dependent.

That signalling caused yields to tumble on Thursday but ECB policymakers on Friday stressed that another rate hike is still a possibility if inflation fails to fall as expected. Latvia's central bank governor Martin Kazaks said policy could still be tightened again if needed.

"I'm comfortable with the current level of rates and I think we're on track to reach 2% in the second half of 2025," he told Reuters on the sidelines of a meeting of European Union financial policymakers in Spain. "But if the data tells us that we need another hike, we’ll do it," he added.

The German 2-year yield was up 5 basis points(bps) at 3.21%, after touching a six-week high at 3.214%. It was set for a 14-bp weekly rise, the biggest since mid-June. ECB President Christine Lagarde said on Friday an interest rate cut was not on the bank's agenda.

"We will be data-dependent and as I said, level and length of time will matter significantly," she said. Money markets slightly increased their bets on the tightening cycle right after the ECB statement on Thursday, pricing in a slight chance of an additional 25 bps rate hike by year-end. They are now pricing a roughly 30% chance of a tightening move by December from around 20% the day before.

Germany's 10-year government bond yield, the benchmark for the euro area, was up 8 bps at 2.671%. It was set to record a 7 bps rise during the week, having dropped 6 bps on Thursday. Most analysts believe the ECB tightening cycle is over, and rates will stay at the current levels for an extended period to tame inflation.

Deutsche Bank analysts said in a research note they forecast a 12-month pause but with upside risks. "If the market prices rate cuts too quickly, the ECB would have to take compensatory policy action, presumably starting with some verbal intervention to underscore what's implied by this policy stance," they argued.

A good appetite for risky assets on expectations that central banks' tightening cycle is close to an end supported a selloff in safe-haven government bonds on Friday. Bond prices move inversely with yields.

Italy's 10-year government bond yield, the benchmark for the euro area periphery, rose 11 bps to 4.46%, after falling 11 bps on Thursday. The spread between Italian and German 10-year government bond yields – a gauge of market sentiment towards the euro zone's most indebted countries – was at 178 bps after hitting its widest level in more than three months at 179.5 bps on Wednesday.

The ECB did not provide any indication about a possible acceleration of quantitative tightening measures, which involve the central bank reducing its asset portfolio. ECB hawks have called for ending reinvestments from bonds bought under the 1.7 trillion euro ($1.82 trillion) Pandemic Emergency Purchase Programme (PEPP) earlier than the current end-2024 deadline.

Such a move might hurt peripheral bond prices as the ECB can flexibly use PEPP reinvestments to avoid excessive yield spread widening, which might hamper the monetary policy transmission.