Euro zone yields edge up after inflation data, eyes on U.S. PCE

EUROPE: Euro zone government bond yields edged higher on Friday as recent economic data suggested central banks' tightening cycle might end later than expected. The bloc's data, which showed only a small drop in underlying inflation, was unlikely to sway the European Central Bank (ECB), which has pencilled in a ninth consecutive rate hike for July and is eyeing one in September too.

U.S. economic data on Thursday solidified the picture of an economy and job market defying predictions of a recession, underpinning pronouncements from the Federal Reserve's chief that there is little room to let up on monetary tightening and affecting expectations about rates in the euro area. U.S. core Personal Consumption Expenditures (PCE) Price Index - a key inflation gauge for the Fed - will be released later in the session, with Berenberg analysts expecting a favourable 0.3% month-on-month increase. They said anything smaller might challenge the Fed's commitment to its current hawkish stance.

December 2023 ECB euro short-term rate (ESTR) forwards rose to 3.9%, implying market expectations for a depo rate of around 4% by year-end. ECB ESTR forwards no longer imply a 25 basis points (bps) rate cut by the first half of next year.

Germany's 10-year bond yield, the benchmark for the euro zone, was up 2 bps at 2.43%. It looked set to end the week with a rise of 7.5 bps. Euro area borrowing costs have been range-bound in the last few weeks, with traders unwilling to test their recent highs.

Germany's 2-year government bond yield, more sensitive to expectations for policy rates, was up one bp at 3.27%. It hit its highest level since October 2008 of 3.385% in early March before fears of a banking crisis led to market bets on policy rates dropping to as low as 3%. UBS economist Arend Kapteyn said "global core inflation (ex food and energy) has retraced 65% of the pandemic run-up".

"That will be little solace to central banks, who would want to see the monthly pace annualizing much closer to target, but it's a significant improvement from earlier in the year," he added in an emailed comment. The German yield curve eased its inversion on Friday, with the gap between 10-year and 2-year yields tightening to 83 bps after hitting its lowest level since September 1992 on Thursday at 90.5 bps.

An inverted yield curve means that markets expect rates to drop in the medium term, and it is usually a reliable indicator of a future recession. Italy's 10-year bond yield, the benchmark for the euro zone periphery, rose 3 bps to 4.12%.

The spread between Italian and German 10-year yields widened slightly to 168 bps. Italian Prime Minister Giorgia Meloni said earlier this week a parliament vote on the European Stability Mechanism (ESM) would not happen, and linked the debate to ongoing discussions on a broader reform of European budget rules.

The ESM is a fund created in 2012 after the euro zone sovereign debt crisis to provide a financial firewall for members of the currency bloc.