Euro zone yields near multi-year highs; investors ponder inflation outlook 

Euro zone bonds weakened on Tuesday, with yields just shy ​of multi-year highs hit the previous day when investors braced ​for a sustained period of high energy prices ‌that ​could spill over into broader inflation and cause central bank rate hikes. Helping the mood on Tuesday was a social media post from U.S. President Donald Trump saying he had paused a planned attack against ‌Iran after Tehran sent a peace proposal to Washington, and that there was now a "very good chance" of reaching a deal limiting Iran's nuclear program. That sent Brent crude down 1.3% to $110 a barrel, but the price is still around 80% higher than it was before the onset of the conflict ‌nearly three months ago. Germany's 10-year yield, the benchmark for the euro zone, was up 3 basis points at 3.191% , its ‌highest since 2011. The yield has risen by half a percentage point since the war began in late February. Global bond markets have been broadly moving in line with each other, as central banks around the world all keep a wary eye on energy costs and their impact on inflation.

On Tuesday, the 10-year Treasury yield rose another ⁠4.4 bps to ​4.67%, around its highest in a ⁠year. Elsewhere in Europe, Italian 10-year yields rose 2.5 bps to 3.97%. However, analysts at UBS said in a note they thought "the market may be underestimating cross-country differences in economic ⁠impact and central bank reaction functions."

They say the fact that the euro area is facing a larger economic hit from the war should limit the ​amount of European Central Bank rate increases, and so, support euro zone bonds. UBS analysts see the gap between U.S. and German ⁠10-year yields widening to 150 bps from its current 144 bps.

Markets currently see around an 80% chance of a 25 basis point ECB rate hike next month and see ⁠two ​further such moves as likely by year end. They are not fully pricing any Fed hikes this year, though last week's hot inflation data left traders pricing in a 60% chance of one 25 bp hike by the end of the year, and markets have long priced ⁠out earlier expectations of rate cuts. UK government bonds outperformed on Tuesday. Yields on the benchmark 10-year gilt were flat at 5.12%. Data earlier showed ⁠Britain's employers reduced hiring and ⁠posted fewer job vacancies in April, prompting investors to cut their bets on Bank of England interest rate hikes. Shorter-dated yields in the euro zone were also roughly aligned with longer-dated ones on Tuesday. Germany's two-year yield ‌rose 2.6 bps to ‌2.75%.

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