Euro zone bonds drop after recent rally, ample supply weighs on prices

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LONDON — Euro zone government bond prices fell on Thursday, halting a rally earlier in the week on signs that inflation may have peaked in the bloc, with heavy government bond supply adding to pressure on prices.

Preliminary inflation data from Germany, France and Spain all showed consumer prices rose at a slower pace in December than November, following an easing in energy price rises.

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Italy, the 20-nation euro area’s third largest economy, was to release its December consumer prices data at 1000 GMT, before the euro zone-wide release on Friday.

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Germany’s 10-year government bond yield, the benchmark for the bloc, was last up 3 basis points (bps) to 2.31%. It has fallen 25 bps this week after closing out 2022 at its highest level since 2011. Yields move inversely with prices.

Germany’s 2-year yield, which is sensitive to changes in interest rate expectations, was up 4 bps to 2.627%.

“Both the German and French inflation data are encouraging and support the narrative that inflation has peaked in Europe,” said Mohit Kumar, chief financial economist Europe, interest rate strategy at Jefferies.

However, Kumar noted that core inflation, which strips out volatile energy and food prices, remains “sticky,” which he said should provide some ammunition for European Central Bank policymakers who prefer higher interest rates.

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Thursday’s focus was on a heavy supply pipeline with France due to conduct its first auctions of 2023 in long-end government bonds (OATs) for an overall amount of 10.5-12 billion euros.

Portugal and Ireland are also expected to sell new syndicated long-end debt via syndication. Both transactions are expected to take place Thursday, subject to market conditions.

“While the constructive market backdrop should remain intact, also with Italy’s CPI probably adding to the inflation relief, the supply digestion could weigh on the bullish dynamics,” Commerzbank’s Hauke Siemssen and Rainer Guntermann said in a note.

Euro zone government bond issuance is set to balloon this year as governments across the bloc raise funds in an attempt to soften the blows from soaring energy prices.

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The European Central Bank is also scheduled to start offloading its holdings of government debt, known as quantitative tightening (QT), which could further keep bond prices under pressure in 2023.

Meanwhile, minutes from the Federal Reserve’s December meeting released on Wednesday showed policymakers remain committed to raising rates to cool inflation, even as they slowed their pace of tightening last month.

“In our view, there was nothing too new to be gleaned with respect to the policy outlook,” said Kevin Cummins, chief U.S. Economist at NatWest Markets.

“The minutes mostly avoided fencing in the committee with any new guidance around the size of the upcoming expected hike.”

Money markets are fully pricing in a smaller 25-basis-point rate rise from the Fed at its February announcement, with around a 35% chance of the central bank sticking with another 50-basis-point hike, according to data from Refinitiv. (Reporting by Samuel Indyk Editing by Mark Heinrich)