Euro Zone bond yields navigate heightened expectations of rate cuts

Eurozone government bond yields demonstrated a rise but hovered close to multi-month lows, with money markets factoring in approximately 160 basis points of policy rate cuts projected for the year, as indicated on the first trading day of 2024.

Germany's 10-year yield, serving as the benchmark for the Euro area, experienced a notable decline of 55 basis points in 2023, marking its most substantial drop since 2014. The substantial decrease, primarily occurring in November and December, was a result of unexpectedly slowed inflation coupled with signals from the European Central Bank (ECB) hinting at the nearing conclusion of its rate-hiking cycle.

Market observers noted significant fluctuations driven by thin liquidity in late December, witnessing the Bund yield dipping below 2 per cent before sharply reversing above that threshold.

By the end of December, German real yields turned negative for the first time since August, reaching -0.075 per cent, marking their lowest level since June 1, but rebounded slightly to 0.051 per cent on Tuesday.

Commerzbank's rate strategist, Hauke Siemssen, expressed scepticism about negative 10-year real bond yields given the aggressive pricing of ECB cuts. The Bund yield recently rose by 5 basis points to 2.082 per cent, touching 1.896 per cent last week, marking its lowest point in over a year.

The future outlook on the European Central Bank's Euro Short-Term Rate (ESTR) forwards for December 2023 suggested a slight adjustment, settling at 2.28 per cent, indicating expectations for a year-end depo rate of 2.38 per cent and a projected 162 basis points of cuts, slightly lower than the 165 basis points estimated earlier.

Amidst varying viewpoints from ECB members regarding potential rate cuts and inflation goals, Siemssen pointed out supply-related implications, potentially exerting downward pressure on bond prices in the forthcoming week.
Attention now shifts to Eurozone inflation data, particularly Thursday's German figures, which are likely to set the tone for financial markets. Analysts anticipate persistent price pressures in Germany post-temporary value-added tax cuts and increased CO2 taxes, yet don't discount the possibility of unexpected downside surprises.

In contrast, Italy's 10-year government bond yield, the Eurozone's peripheral benchmark, rose by 5 basis points to 3.76 per cent, bouncing from its lowest level since August 2022 at 3.468 per cent last week. The yield spread between Italian and German 10-year bonds widened to 166 basis points from a recent 6-month low of 154.10 basis points.

The Italian bond market found support from various factors, including the slower-than-anticipated reduction in the Pandemic Emergency Purchase Programme (PEPP) reinvestments, a flexible European Union stability pact allowing extended time to curtail public debt, and the anticipation of aggressive rate cuts. These factors bolstered demand for Italian government bonds amidst the prevailing market dynamics.

(with Reuters inputs)