Euro zone yields struggle for direction as markets increase bets on Fed rate cut

Euro zone government bond yields were mixed on Monday as money markets increased their bets on a super-sized 50 basis point rate cut by the Federal Reserve on Wednesday.

The Bank of England and the Bank of Japan will also hold their policy meetings later this week and are expected to keep rates at the current levels.

Money markets fully priced 25 basis points of rate cuts and a 59 per cent chance of a 50 bps move, from around 50 per cent late last week, according to the CME FedWatch tool.

"A rate cut of more than 25 bps seems unlikely -- while the Fed is late in cutting rates, a larger move might be taken as a sign of panic," said Paul Donovan, chief economist at UBS Global Wealth Management.

"Higher frequency cuts rather than larger cuts seem most likely," he added.

Germany's 10-year yield, the benchmark for the euro zone bloc, was up one basis point (bp) at 2.16 per cent.

Citi mentioned Fed Governor Christopher Waller, saying he was open-minded about the size and pace of rate cuts after data showed U.S. employment increased less than expected in August.

"These comments would suggest that the Fed wants to start with small cuts while preserving the optionality to go in bigger steps later," said Jabaz Mathai, head of G10 rate and forex strategy at Citi. "Election timing would also justify a conservative start."

Investors will focus on remarks by Fed Chair Jerome Powell, no matter what the Fed decides on rates.

The Fed decision "is likely to be wrapped up in dovish talk at the press conference," Citi's Mathai added. "Easing financial conditions, or at the very least not tightening them, would be the desired result."

Markets priced in 37 bps of European Central Bank rate cuts by year-end, implying a 25 bps move and an around 50 per cent chance of a second cut.

Italy's 10-year yield was 0.5 bps lower at 3.51 per cent, and the gap between Italian and German Bunds -- a gauge of the risk premium investors demand to hold Italian government bonds -- stood at 135 bps.

Investors closely watch political developments in Italy and France, as the European Union has placed the two countries under a so-called Excessive Deficit Procedure this year.

Italy plans to confirm a commitment to bring its deficit-to- GDP ratio below the EU's 3 per cent ceiling in 2026 in its medium-term structural budget plan to be presented by mid-September.

France's deteriorating public finances will be a major challenge for new Prime Minister Michel Barnier, who faces tough choices such as cutting spending, raising taxes, or losing credibility with EU partners and financial markets.