Euro zone yields fall as risk-appetite fades, markets digest central bank moves

Euro zone government bond yields fell on Friday as risk-appetite faded after Ukraine peace talks stalled, while investors digested the latest moves from central banks.

The Kremlin accused Ukraine of trying to drag out negotiations, while Russian forces kept up their bombardments of besieged cities.

Germany’s 10-year yield, the benchmark for the euro zone, fell 3.5 basis points to 0.356%, after hitting 0.41% on Thursday, its highest since November 2018.

“We didn’t change our forecast for the 10-year Bund yield of 0.5% by year end after the war and after recent central banks’ policy meetings,” Yannick Lopez, head of fixed income at OFI Asset Management, said.

He added that he expected the downside risks to the economy due to the conflict in Ukraine to offset central banks’ commitment to tame inflation.

ECB President Christine Lagarde said on Thursday that accelerating the exit from unconventional stimulus gives the ECB “extra space” between the planned end of its money-printing program this summer and the first interest rate hike in more than a decade.

“A switch in narrative from upside inflation risk to downside growth risk may be close, at least that is the warning from the Bank of England meeting,” Citi analysts said in a research note.

The Federal Reserve raised interest rates and laid out an aggressive plan to tame inflation, while the BoE softened its language on the need for more increases after a 25 bps hike.

“BoE pricing is far too excessive, and the time to ECB lift-off means hikes in 2022 may not get off the ground,” they added.

Money markets are pricing in around 45 bps of ECB rate increases by year-end.

Italy’s 10-year government bond yield dropped 2.9 bps to 1.882%, with the spread between Italian and German 10-year yields at 152 bps.

“The Italian-German yield spread prices in a certain amount of EU fiscal policy,” Andreas Billmeier, European Economist at the Western Asset part of Franklin Templeton, said.

“The general assumption is that EU fiscal rules will not be binding in 2023, while there are expectations of some sort of EU fiscal support scheme for member states,” he added.

European Commission Vice President Valdis Dombrovskis said recently that it would not apply the bloc’s debt reduction rules next year, while the Union is considering joint debt issuance to fund more public spending in the energy and defense sectors.

(Reporting by Stefano Rebaudo, additional reporting Joice Alves, editing by Kirsten Donovan)