Euro Zone Borrowing Costs and Spread Dynamics: Analyzing Recent Trends

Euro zone borrowing costs increased as the Fed projected fewer interest rate cuts. The bloc's yields saw a significant drop after lower-than-expected U.S. inflation. Money markets reduced projected ECB and Fed rate cuts for 2024. German and Italian bond yields fluctuated, with the risk premium widening.

Euro zone borrowing costs rose on Thursday as Federal Reserve policymakers' median projection for the number of interest rate cuts this year fell to just one from three in March. The bloc's yields recorded their biggest daily fall since mid-May on Wednesday after economic data showed U.S. inflation was softer than expected.

Money markets priced in 57 bps of European Central Bank rate cuts in 2024, from 63 bps on Wednesday before the Fed statement, implying one move in 2024 and an around 30% chance of a third cut in 2024. They discounted 44 bps of Fed cuts from 51 bps on Wednesday before the outcome of the U.S. central bank policy meeting. Germany's 10-year yield, the benchmark for the euro area, was up one basis point (bp) to 2.54%. It hit 2.707% at the end of May, its highest level since mid-November.

Germany's 2-year government bond yield, more sensitive to policy rate expectations, was up one bp at 2.97%. It recently hit 3.125%, its highest since mid-November. Italy's 10-year yield rose 3 bps to 3.95%. The yield gap between Italian and German bonds, a gauge of the risk premium investors seek to hold bonds of the euro area's most indebted countries, widened 3 bps to 140 bps. It hit 150.6 bps earlier this week, its widest since February.

The spread between French and German bonds was at 61.4. It recently hit 66.9, its widest since March 2023.

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