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Euro Zone Yields Stabilize as Investors Await US Inflation Data and Central Bank Decisions

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Euro zone yields stabilize ahead of key data and central bank decisions

Euro zone yields remained steady on Monday after experiencing significant volatility last week. Investors are awaiting U.S. inflation data on Tuesday and policy decisions from major central banks later in the week, prompting them to hold off on making major moves.

The rise in borrowing costs on both sides of the Atlantic last Friday, fueled by positive U.S. labor market data, led to a slight scaling back of rate cut expectations for 2024. However, the benchmark 10-year Bund yield closed on Friday with its biggest two-week fall since mid-March. Traders largely maintained their bets that the European Central Bank (ECB) will cut rates early next year.

Aside from the mid-March fall, which was prompted by the collapse of Silicon Valley Bank, the Bund yield was on track for its largest biweekly drop since July 2011. The yield remained flat at 2.26% by late afternoon on Monday, having risen 7.5 basis points on Friday.

Money markets currently reflect expectations of 135 basis points of rate cuts from the ECB in 2024, down from around 145 basis points on Thursday. At the end of November, they were pricing in 80 basis points worth of cuts.

Analysts have adjusted their expectations for future cuts following weak inflation data and changes in market pricing, but they believe central banks will maintain unchanged monetary policies this week.

Goldman Sachs predicts that the Federal Reserve will cut rates for the first time in the third quarter of 2024. They also anticipate the ECB to cut rates by 25 basis points at each meeting starting in April next year.

Regarding the upcoming ECB policy meeting, Citi analysts expect policymakers to resist recent market repricing of rate expectations. They also anticipate a discussion and decision on quantitative tightening (QT) to widen the spread between 10-year Italian bond yields and the euro short-term rate by 5-15 basis points, while maintaining a relatively neutral stance on bonds.

ECB President Christine Lagarde previously suggested the central bank might consider an early end to reinvestments of its 1.7 trillion euro Pandemic Emergency Purchase Programme, which would reduce excess liquidity.

PIMCO portfolio manager Konstantin Veit expressed skepticism about the ECB delivering rate cuts as early as the market predicts due to uncertainties surrounding underlying inflation. Veit believes discussions on changes to PEPP reinvestments may begin at the December meeting, with details potentially emerging in the first quarter of 2024.

Similarly, the Bank of England is expected to keep rates unchanged and maintain a tough stance against talk of interest rate cuts in Britain. This is in contrast to other leading central banks signaling a potential turning point in their fight against inflation.

The Federal Reserve, ECB, and Bank of England are all scheduled to have meetings this week. Meanwhile, Italy’s 10-year yields, the benchmark for the euro area periphery, rose by 0.8 basis points to 4.063%. The spread between Italian and German 10-year yields, which measures the risk premium investors demand for holding bonds from heavily indebted countries, stood at 178 basis points after falling to 170 basis points.

Markets will closely monitor the Bank of Japan policy meeting next week, as there is speculation that the bank could drop its negative interest-rate policy as early as January. Analysts have cautioned that a significant increase in domestic yields could lead to capital outflows from global assets, including euro area and U.S. sovereign bonds.

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