Euro Zone Yields Edge Higher After Plunging On U.S. Inflation

Euro zone bond yields were a touch higher on Friday after plunging the day before when U.S. inflation data showed signs of cooling off, supporting the view that the Federal Reserve could slow its tightening pace in December.

Germany's 10-year yield was up 4.5 basis points at 2.051% after dropping 17.5 bps on Thursday, its joint-largest one-day drop since Oct. 3.

The 2-year yield, more sensitive to changes in interest rate expectations, was up 6.5 bps to 2.038% after dropping 14.5 bps on Thursday.

Data released on Thursday showed the U.S. core consumer price index (CPI), which strips out food and energy components, rose 0.3% in October after rising 0.6% the month before. Economists polled by Reuters expected core CPI of 0.6%.

Analysts said lower-than-forecast inflation would likely see the Fed raise rates by a smaller 50 basis points in December after four consecutive 75 basis point hikes, although it was not likely to alter the view that rates will need to move into restrictive territory.

"The data consolidates the view that the next Fed meeting will see a 50 basis point hike," said Lyn Graham-Taylor, senior rates strategist at Rabobank, who is calling for a peak in interest rates at 5%.

"We still think that this shouldn't be the start of a big risk rally as the easing of financial conditions works against the Fed's policy tightening. Our gut feeling was that the move yesterday was overdone," Graham-Taylor added.

In the euro area, German consumer prices, harmonised to compare with other European countries, were 11.6% higher year-on-year in October, confirming preliminary figures.

Meanwhile, European Central Bank policy maker Joachim Nagel called for the central bank to begin shrinking its balance sheet alongside interest rate hikes to help bring inflation down in the euro zone.

ECB speakers on Friday include Vice-President Luis de Guindos, Chief Economist Philip Lane and executive board members Fabio Panetta, Pablo Hernandez de Cos and Robert Holzmann.

Italy's 10-year government bond yield was up 3.5 bps to 4.039%, pushing the closely watched gap between German and Italian 10-year yields below 200 bps, having earlier touched its joint-tightest level since July at 197.4 bps.

Still, analysts said the outlook for Italian bonds was less favourable as the ECB was expected to formalise plans to begin selling part of its bond holdings, or so-called quantitative tightening (QT), next year.

"We're struggling to see how ECB QT doesn't see Italian bonds suffer," Rabobank's Graham-Taylor said.

"The fact we're going into what we believe will be a fairly large recession, we struggle to see how Italian bonds don't suffer during that process."

Eyes were also on geopolitical developments as China eased some of its heavy-handed COVID rules on Friday and Russia said it planned to withdrawal forces from Kherson in Ukraine earlier in the week.

"Geopolitics is difficult to predict, but the news should be a positive for markets," said Mohit Kumar, interest rate strategist at Jefferies.