Euro zone bond yields edge up, Italian-German spread hits fresh 26-month low

LONDON: Euro zone borrowing costs edged up on Thursday as investors digested stubborn U.S. core inflation data, while the yield gap between Italian and German bonds hit a new 26-month low. Investors keen on locking in returns close to the highest levels in over a decade and increasing risk appetite supported demand for Italy's BTPs. Bond prices move inversely with yields.

U.S. Treasury yields rose further on Wednesday as traders speculated that sticky U.S. inflation may convince the Federal Reserve to hold off on cutting rates until after June, the timeframe currently priced in by markets. European Central Bank officials failed to trigger any market action, as chief economist Philip Lane backed a possible cut in June and policymaker Isabel Schnabel talked about the review of the ECB operational framework.

The yield spread between Italian and German 10-year government bonds was last at 118 basis points (bps) after hitting 117.40, its lowest level since mid-January. Investors closely watch the spreads’ tightening across bond markets as they put aside concerns about Italy's budget deficit and reckoned that a resilient economy will control the critical debt-to-GDP ratio.

"The narrative from last week has not really changed, and BTPs still look cheap compared to broader iBoxx," Citi said in a note to clients. iBoxx indices are based on the average values of government bonds, sub-sovereigns, collateralized and corporate bonds.

"We continue to see tightening as more likely than widening, towards 100-110 bps for 10-year BTP-Bund, but wait for better entry levels for new longs," it added. Italy's budget deficit was far higher than targeted last year, but its public debt still fell thanks to strong inflation and higher-than-expected economic growth, data showed on Friday.

"As even the budget deficit figures interrupted the spread tightening only for one day, a global risk reversal would probably be needed to turn things around," said Hauke Siemssen, rate strategist at Commerzbank. "Yesterday's ECB announcements did nothing to counter the solid BTP spread tightening trend, which remains driven by the hunt for carry," Siemssen said, referring to the European Central Bank's operational framework review.

Germany's 10-year yield, the benchmark for the euro zone, was last up one bp at 2.37%. Investors await U.S. economic data later in the session. After consumer prices increased solidly and job growth accelerated in February, investors will look for additional signs of resiliency from the U.S. economy.

The ECB wants to wean banks off free cash but will try to do so gently enough not to upset the financial system or lending, as the result of its long-awaited Operational Framework Review showed on Wednesday. "This outcome largely aligns with market expectations for a demand-driven floor system with practically no impact in the near term, especially since the ECB decided to leave the minimum reserve requirement unchanged," said in a research note Carsten Brzeski, global head of macro at ING.