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German bonds set for best start to the year since 1977

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LONDON: Euro zone government bond prices held steady on Friday ahead of US employment data, as expectations for more benign inflation readings in the bloc kept German yields on course for their largest drop for the first week of the year in over 40 years.

German 10-year bond yields, which serve as a benchmark for the broader euro zone, were down 1 basis point on the day at 2.295 per cent. But they have fallen by almost 30 bps this week and were on Friday heading for their largest weekly decline since late October and, according to Refinitiv data, the biggest in the year's first week since 1977.

Yields move inversely to prices.

Lower consumer inflation readings in Germany, France and Spain have prompted investors to reassess how far interest rates are likely to rise.

"This is a very, very meaty decline in European rates. Ten-year Bund yields are down 30 basis points in the first three days," Rabobank senior rates strategist Richard Maguire said.

"This is the product of weaker-than-anticipated inflation data in the euro zone, the decline in energy prices on the back of the unseasonably warm weather and speculation that 'peak inflation' is now behind us," he said.

That was fuelling hopes that the European Central Bank rate path might be less aggressive than expected, he added.

Energy prices, which rocketed last year after Russia's invasion of Ukraine disrupted flows of natural gas to Europe, have eased, offering some much-needed respite to households and businesses and taking some pressure off the ECB.

A month ago, money markets were pricing in that ECB rates would peak at around 2.8 per cent by September in this tightening cycle. But after President Christine Lagarde signalled at the bank's December meeting that this was too low, markets priced a rate of 3.5 per cent.

Now, that rate is expected to be around 3.37 per cent.

Yields on the bonds of more heavily indebted nations such as Italy have fallen more sharply. Italian 10-year BTP yields have dropped by more than 35 bps this week. They were last unchanged on the day at 4.321 per cent.

Data on Friday showed consumer inflation in the euro zone slowed to 9.2 per cent in December from 10.1 per cent the previous month, below forecasts for 9.7 per cent. But the biggest part of the decline was down to energy prices falling, meaning that the cost of many other essential goods and services, as well as wages, is still rising, and is well above the ECB's target rate of 2 per cent.

"Even with inflation past its peak, it's still a multiple of that target," Maguire said.

The main risk event for Friday is the monthly US non-farm payrolls report for December. Economists expect the data to show 200,000 jobs were added last month, which would be the smallest gain in two years.

Robust figures for US weekly unemployment claims and private-sector employment on Thursday prompted a sell-off in Treasuries, which spilled into the European market.

Adding another drag on bonds were minutes from the Federal Reserve's latest meeting that showed policymakers do not believe financial conditions are tight enough, which would warrant more rate rises than the market is currently pricing in.

A drop in the hourly earnings rate, which is currently up 5.1 per cent year on year, could ignite another rally in bonds, analysts said.

"There's lots at stake as we face into this report," ING strategists said. - Reuters

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