Long-dated euro zone yields set to end week in middle of range

Long-dated euro zone government bond yields were set to end the week slightly lower but in the middle of their range as investors balanced dovish remarks from European policy makers and signals of cooling inflation with strong U.S. job data.

Borrowing costs in the euro bloc recently dropped after data from Britain and the U.S. showed a slowdown in inflation, and hawkish ECB officials, including Dutch central bank chief Klaas Knot, said a rate hike in September might not be necessary.

However, they were sent higher by data on Thursday showing the number of Americans filing new claims for unemployment benefits unexpectedly fell last week, boosting expectations the Federal Reserve may continue hiking interest rates if the economy remains strong.

Germany's 10-year government bond yield (DE10YT=RR), the bloc's benchmark, was down 2 basis points (bps) at 2.43% and 4.6 bps lower on the week, set for its second straight weekly decline in succession.

It hit its highest level since March 9 at 2.679% on July 10 and has remained above 2.15% since early April.

The European Central Bank, the Fed, and the Bank of Japan are set to hold policy meetings next week, setting the tone for government bond markets through the summer.

Some analysts forecast that an expected rate rise by the ECB at the coming meeting could be the last in this tightening cycle, if economic data from now to September confirms inflation pressures are fading.

Money markets are currently fully pricing in a 25-basis-point rate hike by the ECB next week and just around a 55% chance of a further move in September. (ECBWATCH)

The ECB will raise interest rates by 25 basis points, according to all economists in a Reuters poll, a slight majority of whom were now also expecting another hike in September.

Markets will focus on whether ECB President Christine Lagarde reiterates that there is still more ground to cover to bring rates to sufficiently restrictive levels.

Analysts expect Lagarde to provide "purely data-driven guidance" - which means not mentioning that more tightening is needed - or to stress conditionality and uncertainty in comments about future policy.

The ECB "will not clearly signal another hike" at its September meeting, said Christoph Rieger, head of rates and credit research at Commerzbank. Rieger thinks current market dynamics point to lower yields.

Germany's 2-year government bond yield (DE2YT=RR), the most sensitive to expectations on policy rates, dropped 3 bps to 3.23%. It is still just 16 bps away from 3.393%, its highest level since October 2008, which it hit on July 6.

ECB euro short-term rate (ESTR) forwards (EUESTECBF=ICAP) showed a peak in December 2023 at 3.9%, implying market expectations for a deposit rate at 4% by the end of this year.

Some analysts said markets wouldn't be surprised if the ECB paused its tightening in September and hiked rates again at the following policy meeting.

Italy's 10-year government bond yield IT10Y, the benchmark for the euro area's periphery, fell 4 bps to 4.07%.

The spread between Italian and German 10-year yields (DE10YT=RR) tightened to 162.6 bps.