Euro zone bond yields edge higher ahead of U.S. CPI

LONDON: Euro zone government bond yields edged higher on Wednesday morning ahead of key U.S. inflation data due later in the session, which could play a part in whether the Federal Reserve tightens policy further at its meeting in June.

Germany's 10-year government bond yield, the euro area's benchmark, was up 2 basis points (bps) at 2.356%. Germany's 2-year yield, more sensitive to changes in interest rate expectations, was also up 2 bps at 2.684%.

The Consumer Price Index (CPI) likely increased 0.4% last month after rising just 0.1% in March, according to a Reuters poll of economists. That would keep the annual increase in the CPI at 5%. The annual CPI peaked at 9.1% in June last year, its highest level since 1981. The Federal Reserve last week signalled it may be close to the end of its tightening cycle, having raised its interest rate by a combined 500 basis points since the start of last year, its most aggressive series of hikes since the 1980s.

"If we get lower than expected inflation data then we'll see a fairly positive bond market," said Jens Peter Sørensen, chief analyst at Danske Bank. Bond yields move inversely to prices. "An upside surprise would confirm the view that the Fed needs to do more, but not significantly more," Sørensen added.

The European Central Bank meanwhile still has further to go to bring inflation back to target, policymakers have said. ECB board member Isabel Schnabel said the central bank will continue raising borrowing costs until it sees core inflation decline sustainably, adding market expectations for rate cuts were misplaced.

Other members of the ECB's rate-setting governing council also expect additional rates hikes this year, but markets are pricing just under two additional 25 basis point rate increases before rate cuts early next year, according to Refinitiv data. "Markets are definitely not buying what the ECB is saying," Danske Bank's Sørensen said.

"If inflation falls in the U.S. then inflation will fall in the euro area, and if the Fed starts cutting rates, the ECB will follow. It's just a matter of timing," Sørensen added. Meanwhile, eyes were also on negotiations to raise the U.S. debt limit, with President Joe Biden and top lawmakers agreeing on Tuesday to further talks to break the impasse, with around three weeks until the country may be forced into an unprecedented default.

Yields on short-dated U.S. Treasury-bills have surged in recent weeks as investors sold off bonds that could mature around the time the U.S. reaches its debt limit. The yield on the one-month T-bill briefly hit 5.827%, its highest level since at least August 2001, according to data from Tradeweb.

Italy's 10-year government bond yield, was up 2 bps at 4.291%, keeping the spread between Italian and German 10-year yields steady at around 192 bps.