Euro zone yields drop, markets briefly price 100 bps of 2024 rate cuts after ECB decision

Euro zone government bond yields extended falls on Thursday after the European Central Bank revised down its economic projections before returning towards previous levels as ECB President Christine Lagarde said data were not good enough yet to pave the way for rate cuts.

Euro zone government bond yields extended falls on Thursday after the European Central Bank revised down its economic projections before returning towards previous levels as ECB President Christine Lagarde said data were not good enough yet to pave the way for rate cuts. The ECB left interest rates unchanged as expected but acknowledged that inflation was easing faster than once thought, supporting expectations for monetary easing later this year.

"We are making good progress toward our inflation target, and we're more confident as a result, but we are not yet sufficiently confident," Lagarde said during her press conference, adding the ECB is still in the "holding season" when arguing about monetary easing. Germany's 10-year bond yield, the benchmark borrowing cost for the euro zone, was last down 2.5 basis points (bps) at 2.31%.

ECB euro short-term rate (ESTR) forwards briefly priced in up to 102 bps of rate cuts in 2024, from 92 bps before the ECB's policy statement and forecasts. They last discounted 95 bps. They priced an 85% chance of a 25 bps cut by June after almost fully pricing it in after the initial statement.

"The downward revision in economic forecasts led bond yields lower and markets to price more rate cuts in 2024," said Massimiliano Maxia, senior fixed-income product specialist at Allianz Global Investors. "But then Lagarde reiterated that the ECB will not have enough data to cut rates before June," Maxia added, confirming his expectations for two or three 25 bps moves in 2024.

Bond yields have risen in 2024 - with the German 10-year yield up around 30 bps - as investors have reined in expectations for rapid and steep interest rate cuts, with economic data coming in stronger than expected and central bankers sticking to a tough line on inflation. "The big surprise was the revision of the core inflation profile," said Andrzej Szczepaniak, European economist at Nomura. "But ECB communications had also a hawkish side underscoring the need for caution and patience."

Germany's 2-year bond yield, which is sensitive to ECB rate expectations, was down 5 bps on Thursday at 2.82%. "We believe it (the ECB) will proceed cautiously in conventional 25 basis point steps," said Konstantin Veit, portfolio manager at PIMCO, which expects three cuts this year.

"Risk management considerations also play a role, as the reputational costs of having to reverse course once the cutting cycle starts are high," he added. Italy's 10-year bond yield was 5 bps lower at 3.61%, with the spread over Germany's 10-year yield -- a gauge of the risk premium investors ask to hold bonds of the euro area's most indebted countries -- falling to 128.8 bps, its lowest level since January 2022.

Analysts said appealing returns and lack of short-term political and economic risks supported demand for Italian bonds.