Euro zone yields set to end the week higher as bets on rate hike increase

LONDON: Euro zone government bond yields were on track to end the week higher after some inflation concerns and hawkish remarks by European Central Bank's policymakers led money markets to increase their bets on a further rate hike.

A rally in oil prices and solid U.S. economic data on Wednesday showing the services sector unexpectedly accelerated in August have fuelled concerns that central banks might need to do more to win their battle against inflation. However, oil receded from its 10-month highs on Thursday and Friday, as fears about the health of China's slowing economy and a stronger U.S. dollar wiped out the gains triggered by supply cuts from major producers Saudi Arabia and Russia.

Money markets updated their expectations for the ECB's rate rises, and they are currently pricing in an around 40% chance of a 25 basis points (bps) rate hike next week from 20% last week and a 70% chance of the same increase by year-end, from 60%. ECB policy hawks underlined the need of a rate hike next week.

The ECB will hold interest rates steady on Sept. 14, according to a majority of economists polled by Reuters, but just under half expect one more rise this year. Germany's 10-year government bond yield, the benchmark for the euro area, dropped 1 bp to 2.61%. It was set to end the week up 6.5 bps.

Analysts also expect policymakers to start a debate about accelerating the reduction of the ECB's huge bond portfolio by bringing forward the deadline for the Pandemic Emergency Purchase Programme's (PEPP) reinvestments. The ECB planned to end PEPP's reinvestments at the end of 2024. Such a move might affect yield spreads between core and peripheral bonds.

ECB president Christine Lagarde deemed PEPP reinvestments as the first line of defence to avoid an excessive spread widening, which might hamper the transmission of the monetary policy. Analyst views about the possible impact of an acceleration of quantitative tightening (QT) measures are mixed.

"We expect the ECB to accelerate quantitative tightening measures by bringing forward the deadline for the PEPP reinvestments by several quarters," said Reinhard Cluse, chief European economist at UBS, arguing that the ECB council should discuss the issue in October or later. "We see the ECB gently running a passive QT process," avoiding any market disruption, he added.

Italy's 10-year government bond yield, the benchmark of the euro area's periphery, fell 2 bps to 4.33%. The spread between Italian and German 10-year yields was at 171 bps after reaching its widest level in almost a month on Thursday at 175.5 bps.

"PEPP QT is likely surging up the agenda, putting EMU spreads on alert for widening risk," Citi analysts argued in a research note.