Euro zone and U.S. yields fall as focus shifts to Fed

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Euro zone yields fell on Tuesday along with their U.S. peers as market focus shifted to the Federal Reserve policy meeting, with investors looking for cues that the central bank might be considering slowing down its policy-tightening path.

Yields in the 10-year Bund recently rose back to levels seen right before last week’s European Central Bank gathering as strong inflation data overshadowed ECB president Christine Lagarde’s remarks perceived as dovish.

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Analysts expect the Federal Reserve to slow its aggressive rate-hike pace in December, while backing a fourth straight 75-basis-point rate hike on Wednesday.

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U.S. Treasury yields were down in London trade with the 10-year dropping 13 basis points (bps) to 3.94%.

Germany’s 10-year yield fell 9.5 bps to 2.06%. It was at around 2.2% last Thursday before the ECB policy meeting and fell as low as 1.96% the day after.

Italy’s 10-year government bond yield fell 12.5 bps to 4.18%, with the spread between Italian and German 10-year yields at 211 bps.

The ECB must keep raising interest rates to fight inflation, even if the probability of a euro zone recession has increased, Lagarde said in an interview on Tuesday.

As for the Fed, “investors should really be looking for anything that indicates more clearly what the terminal rate will be and how quickly we will get there” said MFS chief economist and portfolio manager Erik Weisman.

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“(The view of) another 75 bps in December would indicate the Fed is nowhere near done. But a hint at 50 bps in December might be the sign that the Fed is moving towards greater incrementalism,” he added.

Investors are also looking toward the Bank of England policy meeting due on Thursday with the BoE set to raise borrowing costs, even as it prepares for a recession.

According to BofA analysts, the BoE will vote 7-2 in favor of raising the Bank rate 75bp.

“We expect the BoE to speed up rate hikes because fiscal policy is more stimulatory near term and the BoE’s Decision Maker Panel signaled more inflation persistence,” they said.

“We think the BoE may also want to bolster credibility.”

Furthermore, analysts flagged the BoE will sell gilts for the first time as active quantitative tightening begins. The 3 to 7-year gilt operation will occur on Tuesday at 1415-1445 GMT.

“For outright, the main market impetus looks set to come from the final key U.S. data ahead of the FOMC decision on Wednesday,” Commerzbank analysts said in a note to clients.

“Our economists expect the headline ISM to drop below 50 for the first time since May 2020.”

The Institute for Supply Management (ISM) will release its purchasing manager index later today.

(Reporting by Stefano Rebaudo, editing by Ed Osmond and Bernadette Baum)