Euro Zone Bond Yields Dip Amid Anticipated Fed Policy Easing

Euro zone government bond yields fell, set to end the week lower, following Federal Reserve Chair Jerome Powell's statement supporting a strong labor market and imminent policy easing. Markets reacted by betting on future rate cuts from both the Fed and the ECB. Investors also assessed recent economic data and upcoming political developments in France.

Euro zone government bond yields dropped and were set to end the week lower after Federal Reserve Chair Jerome Powell on Friday said the U.S. central bank would support a strong labor market. Powell endorsed a policy easing and stated that further cooling in the job market would be unwelcome.

Markets slightly increased bets on future Fed rate cuts, pricing in 102 basis points (bps) by year-end compared to 97 bps before Powell's speech. Germany's 10-year government bond yield dropped 2 bps to 2.22%, standing at 2.26% before Powell spoke and poised to end the week 3.5 bps lower.

"They don't want further weakness so another rise in unemployment to 4.4% or 4.5% could trigger a 50 bps move by the Fed," said James Knightley, chief economist U.S. at ING. Markets discounted 33 bps for September, reflecting expectations of a 25 bps Fed cut and a 30% chance of a 50 bps reduction.

Markets priced in around 70 bps of European Central Bank (ECB) rate cuts by year-end, up from 65 bps before Powell's speech. An increasing number of ECB policymakers support another rate cut in September, with major data surprises in the coming weeks being the only potential delay, according to several sources.

Italian 10-year government bond yield, the euro area's periphery benchmark, dropped 5 bps to 3.56%, while the yield spread with its German peers tightened to 133 bps. The gap between German and French borrowing costs, an indicator of the risk premium for France's government bonds, was 70 bps.

Political developments in France are being closely watched as President Emmanuel Macron faces significant challenges. Parliamentary approval of the 2025 budget is crucial as France is pressured by the European Commission and bond markets to reduce its deficit, with Macron meeting party leaders to establish a new prime minister.

Investors were also evaluating economic data after euro area borrowing costs ended a four-day decline on Thursday. Analysts noted that the Paris Olympic Games positively impacted the French service sector sentiment, which rose by 4.9 points to 55.0, driving a positive surprise in euro area PMIs.

Euro zone wage growth slowed in the second quarter due to a major slowdown in Germany. Christian Schulz, European economist at Citi, mentioned that negotiated wage growth in Germany is expected to re-accelerate in the third quarter, driven by a significant one-off payment in the wholesale sector.