Euro zone government bond yields edged higher on Monday with market bets about future policy rates close to the upper end of analyst forecasts.

President Christine Lagarde reiterated on Friday that the European Central Bank (ECB) would raise interest rates again next month before taking further decisions based on how the economic data pans out.

ECB’s hawkish Peter Kazimir said “a continuation of monetary policy tightening is the only reasonable way ahead”.

Major global investment banks lifted their terminal rate forecast for the ECB to 4% in September.

Germany’s 10-year government bond yield (DE10YT=RR), the bloc’s benchmark, was up 3 basis points (bps) at 2.49%.

It fluctuated between 2.2% and 2.55% since around mid-April when fears of a banking crisis, which led the Bund yield to drop below 2%, faded.

Investors are worried about what effect the quickest rate-hiking cycle since the adoption of the euro will have on the 20-country currency bloc’s economy, with some still fretting about other potential skeletons in the banking sector’s closet.

Germany’s policy-sensitive 2-year yields (DE2YT=RR) rose one bp to 3.18%. They hit a 3-month high on Friday at 3.206%.

Analysts flagged that Kristalina Georgieva, managing director of the International Monetary Fund, argued last week that the ECB should continue to focus on bringing down inflation but must carefully calibrate monetary policy to avoid a hard landing in the continent’s economy.

November 2023 ECB euro short-term rate (ESTR) forwards (EURESTECBM3X4=ICAP) were at 3.82%, implying market expectations for the depo rate to peak slightly above 3.9%.

ECONOMIC IMPACT

Concerns about the adverse economic impact of the monetary tightening are the main reason behind the pricing of the first 25 bps rate cut by April 2024 with ECB ESTR forwards (EURESTECBM7X8=ICAP) at 3.6%.

German industry association BDI said on Monday it expected the economy to stagnate this year.

Italy’s 10-year government bond yield, the benchmark for the euro area’s periphery, rose 5.5 bps to 4.07%.

The gap between Italian and German 10-year yields (DE10IT10=RR), a gauge of investor confidence towards Southern Europe’s most indebted countries, widened to 158 bps after hitting a new 14-1/2-month low at 149.7 bps on Friday.

Analysts flagged that investment funds have been piling back into fixed-income assets to lock in the higher returns on offer, with Italian bonds in the spotlight as they deliver enticing yields while benefiting from an ECB backstop – the Transmission Protection Instrument — to avoid risks of disorderly selloffs.

Citi’s European strategists said, in a research note, they didn’t “see a near-term reversal (in spread tightening) as European government bond supply is likely to drop sharply (this week) from last week’s year-to-date high”.

Analysts also argued that Italian government bonds are more subject to investors’ risk-on, risk-off trading when investors buy risky assets on the back of data or events which lead to expectations for favourable economic conditions while selling in the opposite scenario.

Investors who want to be exposed to risky assets can buy in the very liquid BTPs future market.