Euro zone bond yields inch up; trade, monetary policy in focus

Euro zone government bond yields inched higher on Wednesday but remained within their recent range as trade uncertainty, monetary policy expectations and the approval of U.S. President Donald Trump's tax and spending bill kept investors guessing.

The 90-day pause that Trump activated following the market chaos unleashed by his April 2 "Liberation Day" tariff announcement expires in a week. "Our overall view on tariffs remains that while they would cause uncertainty and near-term volatility, eventually we see average tariffs settling around the 10-15% level," said Jefferies economist Mohit Kumar.

"It would still have a negative macro impact but 10-15% is a level that the world can live with." European Central Bank President Christine Lagarde said this week the euro zone was facing increased volatility in inflation, which would mean the central bank having to act more forcefully to keep price pressures around its 2% target.

Euro zone consumer price inflation edged up to the ECB's target in June, data showed on Tuesday. Germany's two-year yield, which tends to be the most sensitive to changes in rate expectations, was up 1.5 basis points on Wednesday at 1.86%.

The benchmark 10-year Bund yield rose 3 bps to 2.596%, in line with the 10-year Treasury yield, which rose to 4.287%, up from its lowest level since early May that it hit the day before. Two ECB policymakers warned on Tuesday about the hit from a further appreciation of the euro on a weak euro zone economy that is bracing for higher U.S. import tariffs, yet for now, the central bank has signalled rate cuts will likely stay on hold.

"ECB officials agree that after cutting interest rates by 200 basis points, 2% inflation and 2% interest rates could be a sustainable sweet spot to go through trade policy uncertainty and geopolitical risks," said SGH Macro president Sassan Ghahraman. "They acknowledge elevated uncertainty and remain willing to act to address additional inflation undershooting risks."

Money markets show traders are pricing about a 90% chance of one more quarter-point rate cut this year from the ECB, which would bring the benchmark deposit rate to 1.75%, from 2% now. FED RATE CUTS?

For the Federal Reserve, investors price 63 bps of easing, implying two quarter-point cuts and around a 50% chance of a third. Markets reduced their rate cut expectations slightly on Tuesday after strong manufacturing and labour market data. The U.S. payrolls report, released on Thursday this week due to the Independence Day holiday, will give another indication of the strength of the U.S. labour market.

Italy's 10-year yield rose 3 bps to 3.501%, bringing the premium over Bunds to 90.5 bps, according to LSEG data. The spread is close to its lowest in a decade.

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