Euro Zone Bond Yields Show Mixed Reaction Amid Economic Data and Rate Cut Speculations

Euro zone government bond yields experienced mixed movements after the Ifo German business survey reported a decline in business morale for June. The German 10-year bond yield rose slightly, while Italian yields fell. Market expectations for European Central Bank rate cuts in 2024 have strengthened, with significant implications for interest rates and public spending in indebted countries.

Euro zone government bond yields were mixed on Monday after the Ifo German business survey showed that business morale unexpectedly fell in June, supporting expectations for interest rate cuts.

The Ifo Institute said its business climate index declined to 88.6 in June from 89.3 in May, compared with analysts' reading of 89.7 forecast in a Reuters poll. German 10-year bond yield, the benchmark for the euro area, rose 0.5 basis points (bps) to 2.41%.

"The Ifo business climate indicator has been overstating the weakness in the economy for some time," said Jack Allen Reynolds, deputy chief euro zone economist at Capital Economics. "The purchase manager index has been a better guide recently, and while it also declined in June, it still points to a small increase in gross domestic product (GDP) in the second quarter," he added.

Euro zone business growth slowed sharply this month as demand fell for the first time since February, a survey showed on Friday. On top of that, hopes for monetary easing in Europe strengthened after the Swiss National Bank marginally surprised markets by cutting rates, and the Bank of England delivered a dovish message.

Money markets priced in around 70 bps of European Central Bank rate cuts in 2024 late on Friday and early on Monday, implying a 25 bps cut and a 60% chance of a third cut by year-end. They last discounted around 65 bps. Italy's 10-year yield fell 3 bps to 3.91%, while the Italian-German yield gap dropped to 149 bps.

The risk premium over the euro area's most indebted countries tends to decline when hopes for rate cuts strengthen. The French government bond yield gap versus Germany remained within striking distance of its 7-year high as investors worry that a far-right victory could lead the government to increase public spending, fuelling fears of a budgetary crisis at the heart of Europe.

The financial point man for Marine Le Pen's National Rally(NR) told Reuters that an RN-led government would end the decades-long practice of running high budget deficits and stick to the European Union's fiscal rules. "We believe it's too soon to buy French spreads ahead of the first round of elections, given uncertainty about the shape of a new government and its fiscal policies," said Reinout De Bock, head of European rate strategy at UBS.

"The absorption capacity of French bonds is substantial, but the key question is how a new government will halt the upward trend in debt to GDP," he added. The gap between French and German 10-year yields - a gauge of risk premium investors demand to hold French government bonds – was at 71 bps. It recently hit around 80 bps, its highest level since February 2017.

The first round of French elections will take place on Sunday. Market sentiment towards France and the euro area's most indebted countries improved on Thursday as the market got through a French bond auction largely unscathed.

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