Euro zone bonds strengthen as investor nerves jangle

Euro zone government bonds held gains on Wednesday as investors' nervousness over upcoming US jobs data this week has ignited widespread volatility and driven capital flows into traditional safe-haven assets.

Risk aversion this week has racked global markets as concern mounts ahead of Friday's US employment report that could determine the size of any interest-rate cut by the Federal Reserve this month.

The jumpiness is all the greater because September is typically the worst month for equity market returns.

Bund yields posted their largest one-day fall in a month on Tuesday, with a drop of 6 bps, while two-year yields fell by a more modest 3.8 bps.

The European Central Bank, which meets next week, is expected to deliver another quarter-point rate cut. Board member Piero Cipolollone told a French newspaper on Wednesday the central bank had room to lower rates and was at risk of becoming too restrictive.

Benchmark 10-year Bund yields edged down nearly 4 basis points to 2.235 per cent, while two-year yields were down 5 bps at 2.332 per cent.

Commerzbank analysts noted that a steep drop in the oil price on Tuesday has helped the longer end of the Bund curve, as investors factor in how that might further suppress inflation and, therefore, the need for deeper rate cuts.

ECB policymaker Joachim Nagel, who has typically favoured higher rates, was quoted as saying on Tuesday "the great wave of inflation is over", but added he would not decide whether to vote to cut rates in September until next week.

A German trade group on Wednesday sounded the alarm as the country's exporters face a recession in foreign trade. Europe's largest economy is already struggling.

In the short term, fixed income investors will stay focused on swings in the broader markets and on US employment data releases, starting with monthly layoffs and hiring numbers due later on Wednesday.

The wait will be over by Friday, when the US monthly employment report lands. Economists polled by Reuters expect to see a rise of 160,000 in the number of workers on nonfarm payrolls in August, versus July's 114,000 increase.

Until then, government bonds were likely to fluctuate along with investor risk appetite, Jefferies strategist Mohit Kumar said.

"We are keeping our modest bullish bias on risky assets despite yesterday moves, but we are keeping the size of our positions small. As argued yesterday, it is a prudent idea to have some hedges in place as we expect increased volatility over the coming weeks," he said.

Separately, Germany sold around 2.2 billion euros in top-ups of 15-year debt, achieving modestly lower yields and stronger demand.

Elsewhere, Italian 10-year yields were down 2.7 bps at 3.642 per cent, leaving their premium over Bunds flat at 139.9 bps.

French 10-year OATs were down 2 bps at 2.974 per cent.