Yield gap between Italian and German bonds hits 26-month low

The gap between Italian and German yields hit a 26-month low on Wednesday, while the euro area's bond prices struggled for direction, with markets still betting on around 95 basis points (bps) of European Central Bank rate cuts in 2024.

The gap between Italian and German yields hit a 26-month low on Wednesday, while the euro area's bond prices struggled for direction, with markets still betting on around 95 basis points (bps) of European Central Bank rate cuts in 2024. Bond prices move inversely to yields.

Since the ECB policy meeting last week, investors have assumed that the central bank will keep rates at the current levels until June and will gradually cut after that point. Yields on both sides of the Atlantic rose on Tuesday after U.S. inflation figures came in slightly above expectations, raising concerns that the Federal Reserve may not be able to cut interest rates as soon as investors expect.

The spread between Italian and German 10-year yields - a gauge of risk premium investors ask to hold bonds of the euro area's most indebted countries – enjoyed a strong rally this year as appealing returns and appetite for riskier assets boosted demand for Italian government bonds. JP Morgan flagged, in a research note, that the yield gap was at levels seen before the ECB tightening cycle started, arguing that "the recent tightening, intra-EMU spreads, especially Italian spreads, are screening expensive relative to other Euro credit spreads".

The gap between Italian and German yields was last at 125 bps after early in the session hitting 123.80 bps, its lowest level since mid-January 2022. "The air is getting thin around our 125 bps target for 10y spreads, as the ISDA basis (which captures Italy's specific credit factors) is running into very hard resistances," said Michael Leister, head of interest rates strategy at Commerzbank.

Germany's 10-year yield, the benchmark for the euro zone, was last flat at 2.33%. The ECB would probably start cutting rates between April and June 21, as the "victory" against inflation was in sight, French central bank head Francois Villeroy de Galhau said.

Money markets discounted 93 bps of ECB rate cuts in 2024 while almost entirely pricing a first move by June and almost no chance of a rate cut in April. "The longer rates remain restrictive and the slower the ECB is to cut, the bigger the danger that some economic harm becomes apparent," said Chris Attfield, European rates strategist at HSBC, flagging that the ECB assumed unemployment would not rise and that growth would pick up in the second half of 2024.

"The early signs of stress are already visible in January's survey of bank lending, which fell as high rates suppressed credit demand," he added. "These tail risks are not significantly priced into the market at present." The ECB will announce later in the session the outcome of discussions about its Operational Framework Review, a technical but vital exercise that will set rules for how it provides liquidity to commercial banks in the coming years.

"The focus of the review outcome is likely to be on how euro short-term rate (ESTR) will be controlled by future monetary policy – with a demand-driven floor system most likely," Citi said in a note to clients.

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