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German bonds set for best start to the year since 1977

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LONDON — Euro zone government bond prices fell on Friday after U.S. employment data, as expectations for more benign inflation readings kept German yields on course for their largest drop for the first week of the year in over 40 years.

German 10-year bond yields, which serve as a benchmark for the broader euro zone, were down 11 basis points (bps) on the day at 2.20%, the lowest level since Dec. 19.

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They have fallen by 36 bps this week and were on Friday heading for their largest weekly decline since late November 2011 and, according to Refinitiv data, the biggest in the year’s first week since 1977. Yields move inversely to prices.

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U.S. numbers, showing the U.S. economy maintained a strong pace of job growth in December, added to the downside pressure on euro zone rates.

“Bonds are extending their rally because (U.S.) slowing average hourly earnings suggest that future wage growth may decelerate, raising hopes that the Fed will have an easier job tackling inflation,” said Rohan Khanna, rate strategist at UBS.

Lower inflation readings in the euro area earlier this week have prompted investors to reassess how far interest rates are likely to rise.

“This is a very, very meaty decline in European rates. Ten-year Bund yields are down 30 basis points in the first three days,” Rabobank senior rates strategist Richard Maguire said.

“This is the product of weaker-than-anticipated inflation data in the euro zone, the decline in energy prices on the back of the unseasonably warm weather and speculation that ‘peak inflation’ is now behind us,” he said.

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That was fueling hopes that the European Central Bank (ECB) rate path might be less aggressive than expected, he added.

“Euro zone headline inflation data was better than expected as energy prices fell, but the central bank looks at core inflation, which seems to be more sticky,” UBS’s Khanna added.

“So I’d be concerned if the bond rally continues as the ECB’s Governing Council doesn’t want yields to fall further.”

Energy prices, which rocketed last year after Russia’s invasion of Ukraine disrupted flows of natural gas to Europe, have eased, offering some much-needed respite to households and businesses and taking some pressure off the ECB.

“Even with inflation past its peak, it’s still a multiple of that (the ECB’s) target,” Maguire said.

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A month ago, money markets were pricing in that ECB rates would peak at around 2.8% by September. But after President Christine Lagarde signaled at the bank’s December meeting that this was too low, markets priced a rate of 3.5%. Now, that rate is expected to be around 3.30%.

Yields on the bonds of more heavily indebted nations such as Italy have fallen more sharply. Italian 10-year BTP yields have dropped by about 50 bps this week. They were last falling 14 bps on the day at 4.19%, its lowest level since December 15.

A drag on bonds were minutes from the Federal Reserve’s latest meeting that showed policymakers do not believe financial conditions are tight enough, which would warrant more rate rises than the market is currently pricing in.

(Reporting by Amanda Cooper and Stefano Rebaudo; Editing by Tomasz Janowski, Alex Richardson, William Maclean)

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