Euro zone yields rise amid scepticism about ECB slowing tightening

"It's pretty clear that December inflation data won't be able to make the ECB change its policy stance, with EGB markets likely to remain volatile in the near future," said Francesco Maria Di Bella, fixed income strategist at UniCredit. UniCredit said in a research note "the peak rate (according to money market forwards) is expected to be around 3.5% in the euro area, which is a well-balanced judgement".

Euro zone bond yields rose on Tuesday as investors reckoned the economic outlook did not support a potential slowdown in the European Central Bank's (ECB) monetary tightening. Some analysts are wary of forecasting a recession in the euro area due to resilient growth at the end of last year, falling gas prices and China's reopening from COVID restrictions.

Goldman Sachs said in a note on Tuesday it expected the euro area to avoid a technical recession in 2023, forecasting the economy to grow 0.6% this year, compared with its previous forecast of a contraction. Stocks in China on Tuesday snapped a six-session winning streak, driven by the country's end to its zero-COVID policy.

Germany's 10-year government bond yield, the euro area's benchmark, rose 8 basis points (bps) to 2.298%. It hit its highest since 2011 last week at 2.569%. Despite recent volatility in fixed income markets, forward contracts on ECB euro short-term rate (ESTR) hovered around levels seen right after December's ECB policy meeting. The August 2023 ESTR forward was around 3.4% after rising to 3.5% on Dec. 15.

Recent data showing peaking headline inflation in the bloc probably won't be enough to affect the ECB stance as core inflation firmed modestly while policy impulses remain hawkish. Analysts recalled a recent speech by ECB board member Isabel Schnabel - the most influential voice in the hawkish camp – mentioning a policy objective of taking real yields more firmly into positive territory.

Schnabel said on Tuesday financing conditions will need to be more restrictive and inflation will not subside by itself. "It's pretty clear that December inflation data won't be able to make the ECB change its policy stance, with EGB markets likely to remain volatile in the near future," said Francesco Maria Di Bella, fixed income strategist at UniCredit.

UniCredit said in a research note "the peak rate (according to money market forwards) is expected to be around 3.5% in the euro area, which is a well-balanced judgement". An ECB Economic Bulletin article forecast "very strong" wages growth over the next few quarters, but real wages are still likely to decline, given rapid inflation.

"We expect the view of research staff on that topic is something that resonates with governing council members, and by extension with markets," ING analysts said. Italy's 10-year bond yield rose 6 bps to 4.227%. The closely watched spread between Italian and German 10-year yields was at 190 bps; it hit an almost 10-week high at 222 bps a few days after the ECB policy meeting.

"The 200bp mark is emerging as the key hurdle for the 10y BTP-Bund-spread," said Michael Leister, head of interest rates strategy at Commerzbank.

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