German bond yields plunge on concerns over economy, spreads widen

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German government bond yields tumbled on Tuesday as renewed fears about the economic outlook across the euro zone fueled expectations of slower monetary tightening while spreads between core and periphery widened.

Risk appetite and stock markets fell, with the euro sinking to a two-decade low as another surge in natural gas prices reignited worries about the economy’s health.

Investors feared recession over inflation last week while scaling back expectations about future European Central Bank (ECB) interest rate rises and sending German borrowing costs down by around 40 basis points (bps) in three sessions.

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Money markets are pricing in around 135 bps of ECB rate hikes by year end from 140 bps on Monday.

Germany’s 10-year government bond yield fell 12.5 bps to 1.21% on Tuesday after jumping by 11 bps on Monday.

According to Commerzbank analysts, “thin trading liquidity has probably contributed to the rates sell-off yesterday.”

The German benchmark yield hit its lowest since June 1 last week at 1.163%, after reaching its highest since January, 2014 in mid-June at 1.926%.

“We are still a bit positive on Bund (prices) on expectations that the ECB might not fulfill the expected monetary tightening,” said Hetal Mehta, Senior European Economist at Legal and General Investment Management (LGIM).

Bond prices move inversely with yields.

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Activity in Italy and Spain’s services sectors slowed again in June, amid faltering demand.

Italy’s 10-year government bond yield fell 4 bps to 3.31%, while the spread between Italian and German 10-year yields widened 8 bps to 209 bps. . It wobbled between 190 and 215 bps after the ECB pledged its support for the periphery in mid-June.

Spain and Portugal’s spreads also widened by around 6 bps.

The ECB’s biggest shareholder, Germany’s Bundesbank, laid out its conditions for providing new support to the euro zone’s most indebted countries on Monday after opposing such aid at an emergency meeting last month.

But some analysts remained confident that the ECB would deliver on its plan announced in mid-June to tackle fragmentation in euro zone bond markets – an excessive widening of spreads between core and peripheral yields that might hamper monetary policy transmission across the bloc.

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“We don’t expect spreads between core and peripheral bond yields to widen or tighten too much from the current levels before the next ECB meeting,” LGIM’s Mehta argued.

“Investors want to see first if the central bank comes up with a credible anti-fragmentation tool,” she added.

Analysts flagged that the recent decline in nominal rates had been partially driven by a drop in breakevens – a gauge of inflation expectations measured by the difference in yield between inflation-protected and nominal debt.

Germany’s 10-year breakeven rates were at 2.095% on Monday, after hitting their lowest since Feb. 28 at 2.019% on Friday. They have dropped by around 70 bps since the end of April.

(Reporting by Stefano Rebaudo, editing by Ed Osmond)

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