Euro zone yields drop amid bank worries, uncertainty on ECB moves

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Concerns about the U.S. banking system fueled bids for safe-haven government bonds on Wednesday, while money markets nudged down expectations for the European Central Bank’s (ECB) tightening path.

First Republic Bank faces challenging options to turn around its business by creating a ‘bad bank’ or potentially selling assets. At the same time, the Wall Street Journal wrote in an article, including comments from former Dallas Fed President Robert Kaplan, that bank issues had a long way to run.

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ECB hawks kept banging the inflation drum ahead of next week’s policy meeting. Investment banks quoted Croatian central bank Governor Boris Vujcic as saying the ECB had “no choice but to raise rates further” until there was a “change in trend” in underlying inflation.

Germany’s 10-year government bond yield, the euro area’s benchmark, dropped 4 basis points (bps) to 2.34%, after hitting a 2-week low at 2.31%.

German consumer sentiment is set to pick up in May on moderating energy prices and expected wage increases, a GfK institute survey showed.

Market bets on future ECB rate rises have been relatively stable recently. The September 2023 ECB euro short-term rate (ESTR) forward was at 3.63%, implying expectations for a depo rate around 3.73% by fall.

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Investors increased bets on a 25-bps rate hike at next week’s policy meeting, reducing the chances of a 50-bps move to 20% from around 30% the previous days.

However, several analysts do not rule out 50 bps, which would deliver a hawkish signal to markets and involve a potential repricing of the policy rate forward curve.

A market stress indicator such as the gap between two-year euro swap rates and two-year German bond yields hit a fresh one-month high at 82.25 before falling back to 76.3.

“The U.S. banking and debt ceiling concerns are compounding the demand for safety triggered by the crisis,” said Michael Leister, head of interest rates strategy at Commerzbank.

“This is leaving Schatz-(asset swap) spreads with the largest premium since 6 September, at the height of the scarcity hype, judging by our structural fair value model,” he added.

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A Republican bill authorizing a $1.5 trillion increase to the U.S. debt ceiling, which would avoid what Treasury Secretary Janet Yellen deemed a “financial catastrophe,” hit a snag late on Tuesday.

Italy’s 10-year government bond yield was down 2.5 bps to 4.23%.

The spread between Italian and German 10-year yields – a gauge of investor confidence in the more indebted countries of the euro zone – was at 188 bps after expanding to its widest in a month at 190.6 bps.

Citi analysts recalled that Tuesday’s analysis on so-called fallen angels by Moody’s focused on Italy’s lowest investment grade rating, which is on a negative outlook.

The report highlighted risks from partially implementing a new generation fund (NGEU), sluggish growth, high funding costs, and reliance on imported gas, exposing Italy to supply risks.

“However, with politics relatively stable for now and deficit/debt likely to be on a declining path based on our economists’ forecasts, a catalyst for a downgrade to sub-investment grade is missing,” Citi analysts said.

(Reporting by Stefano Rebaudo; Editing by Mark Potter and Emelia Sithole-Matarise)