Euro zone yields fall to levels last seen before ECB’s Dec. meeting

U.S. producer prices fell more than expected in December as the costs of energy products and food declined, offering evidence that inflation was receding.

The ECB in mid-December pledged further rate hikes, triggering a bond sell-off which drove Germany’s 10-year government bond yield from around 2% to its highest since July 2011 at 2.569%.

It dropped later as inflation cooled off and fell more than 10 bps on Tuesday after Bloomberg News reported that ECB policymakers were considering a smaller, 25 bps interest rate hike at the March meeting.

“We had flagged that (ECB) chief economist Philip Lane’s emphasis on the ‘meeting-by-meeting’ approach in his FT (Financial Times) interview had already shown that President Lagarde’s December guidance towards a series of 50bp hikes was being challenged,” Citi analysts said.

Significant rate hikes are justified in the near term to keep inflation expectations under control, ECB policy council member Olli Rehn said.

French Central Bank Governor Francois Villeroy de Galhau said interest rates could peak by the summer. Financial markets currently expect the ECB’s main interest rate to peak at 3.2% in August 2023, according to forward interest rate swaps. That is a step down from December, when traders were betting that rates would peak at 3.5%.

Germany’s 10-year yield fell on Wednesday by 12 basis points (bps) to 1.972%, its lowest since December 15.

Italy’s 10-year bond yield dropped 19 bps to 3.68%, its lowest since December 13.

The gap between German and Italian 10-year government bond yields, a gauge of investor confidence in the more highly indebted countries of the euro zone, narrowed to the lowest level since April 2022 on Wednesday.

Attractive yields and risk appetite triggered by hopes that inflation will cool off faster than expected have supported peripheral bond prices.

The focus of global markets was also on the Bank of Japan, which overnight maintained its policy of yield curve control – through which it anchors the 10-year bond yield at around 0%. It also kept short-term interest rates at -0.1%.

“Today there’s a little bit of a relief from the BOJ not acting,” said Sphia Salim, head of European rates strategy at Bank of America.

Many investors expected the BOJ to further loosen policy after it jolted markets in December by suddenly widening the 10-year bond’s trading band to 50 bps either side of 0%, a move widely read as a sign that further changes were coming.

Traders have been testing the BOJ’s commitment to supporting the bond market, pushing the 10-year yield above the 0.5% upper bound in recent days.

The BOJ might further loosen monetary policy later in the year, potentially after current governor Haruhiko Kuroda steps down in the spring.