Euro zone yields fall sharply on safe-haven demand, ECB policy path repricing

The ECB said on Thursday it might cut rates soon but failed to trigger a repricing of market bets on future rate cuts after strong U.S. economic data led investors to reduce expectations for future monetary easing there. Gold surged to a fresh peak on Friday, supported by safe-haven demand amid the tension in the Middle East.

Euro zone government bond yields dropped sharply on Friday as markets increased bets on future European Central Bank rate cuts and fears of a broadening of the Middle East conflict triggered bids for safe-haven assets. The ECB said on Thursday it might cut rates soon but failed to trigger a repricing of market bets on future rate cuts after strong U.S. economic data led investors to reduce expectations for future monetary easing there.

Gold surged to a fresh peak on Friday, supported by safe-haven demand amid the tension in the Middle East. Market participants said investors were closing some short positions on euro area government bonds opened during two weeks of strong U.S. data and hawkish remarks from Federal Reserve officials, as fears of a confrontation between Iran and Israel and the U.S. weighed on market sentiment.

"We do see geopolitical risks impacting markets a bit more than usual, with investors watching closely developments on Israel and Iran," Joost van Leenders, senior investment strategist at Van Lanschot Kempen, said. Israeli Defence Minister Yoav Gallant said on Thursday that Israel would respond directly to any attack by Iran. The Pentagon said it discussed with Gallant the United States' "iron-clad" commitment to Israel's security against threats from Iran and its proxies.

"Today's fall in yields is all about investors closing short positions they opened after strong U.S. economic data," said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors. Germany's two-year government bond yield, more sensitive to the outlook of policy rates, dropped 7 basis points (bps) to 2.90% and was set to end the week 3 bps higher. The benchmark 10-year Bund yield fell 9 bps to 2.39%.

Money markets last priced in around 83 bps of monetary easing by the ECB in 2024 from 75 late on Thursday and from 87 bps on Wednesday before the U.S. data. They also discounted an around 90% chance of a 25-basis-point first move by June. Markets also priced 45 bps of Fed rate cuts in 2024 from 40 bps the day before, raising to 80% the chances of a second rate cut this year.

The ECB policy meeting was relatively uneventful for the market as the ECB confirmed it would be data-dependent, with economists looking for hints about the future policy path. "We interpret some of the indirect messages on inflation and financial conditions as being on balance more consistent with gradual/quarterly cuts than continuous/back-to-back cuts," Deutsche Bank chief economist Mark Wall said.

"President Lagarde also argued the ECB is independent of the Fed, but at the same time was clear that U.S. data is taken into account," he added. Some analysts said an ECB rate cut in June was probably a done deal but the Fed monetary policy would significantly affect the ECB path beyond.

"Bund yields risk being pulled higher by (U.S.) Treasuries, and a weaker euro in forex terms could also become a factor limiting the ECB over the months ahead," said Mark Dowding, BlueBay CIO, RBC BlueBay Asset Management, after mentioning the need of policy divergence between the Fed and the ECB. The Italian 10-year bond yield was 11.5 bps lower at 3.75%. The gap between Italian and German 10-year borrowing costs – a gauge of risk premium investors ask to hold bonds of the euro area's most indebted countries – tightened to 135 bps.

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