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Euro zone bond yields slip as market weighs Fed, ECB tightening pace

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LONDON — Euro zone government bond yields slipped marginally on Tuesday as traders weighed comments from influential Federal Reserve and European Central Bank policymakers on the future pace of tightening.

European Central Bank policymaker Francois Villeroy de Galhau said the bank expects to raise interest rates above 2%, but beyond that level rate hikes may be in a more flexible and less rapid manner.

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In the United States, Fed Vice Chair Lael Brainard said late on Monday it would likely be appropriate to slow the pace of interest rate hikes soon, adding that last week’s slowdown in overall inflation was “reassuring.”

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“A notable push back on the slightly more hawkish momentum to start the week … from Fed Vice Chair Brainard, who struck a far less hawkish tone than Governor Waller had the previous day,” Deutsche Bank strategist Jim Reid said.

On Sunday, Federal Reserve Governor Christopher Waller said the U.S. central bank was not softening its fight against inflation, even as it considers slowing the pace of rate hikes from next month’s meeting.

Money markets are fully pricing in a 50 basis point rate rise at the Fed’s next meeting in December with just an 11% chance of a fifth consecutive 75 basis point hike, according to Refinitiv data.

Traders expect U.S. rates to peak at around 4.9% in the middle of next year with interest rate cuts priced in before the end of 2023.

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Germany’s 10-year government bond yield, the euro area benchmark, was down 3 basis points (bps) to 2.122%. It dropped 13 bps last week after rising 20 bps the week before.

The two-year yield was down 1 bp at 2.164%, in close proximity to its 14-year high of 2.252% reached last week.

The spread between German 2- and 10-year yields, which turned negative last week for the first time since 2008, remained inverted at minus 4 basis points. Economists often view an inversion of the 2/10 section of the yield curve as a precursor for a recession.

Italian bonds outperformed. The country’s 10-year yield was last down 5 bps to 4.141%. This pushed down the closely watched gap between Italian and German 10-year yields to around 200 bps, although analysts remained cautious on Italian bonds.

“We regard the current 10y spread level of around 200bps as too tight and recommend positioning for a wider spread,” said SEB rates strategist Jussi Hiljanen in a note.

“We expect the spread widening to be boosted by a general weakening of the risk sentiment and the upcoming TLTRO repayments,” Hiljanen added.

At its October meeting, the ECB changed the terms on its multi-year loans to banks, or targeted long-term refinancing operations (TLTRO), to encourage banks to repay them early, in a move designed to mop up excess cash from the system. (Reporting by Samuel Indyk; Editing by Susan Fenton)

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