Euro Zone Bond Yields Tumble Amid Concerns Over Economic Outlook

Euro zone government bond yields fell on Tuesday while money markets scaled back their expectations about European Central Bank's rate hikes amid concerns over the economic outlook due to surging energy prices and potential gas supply cuts.

Physical gas flows through the Nord Stream 1 pipeline from Russia to Germany fell to zero on Monday.

Some analysts forecast a quick monetary tightening in 2022 and a potential stop in 2023 as they expect the euro area economy to slow down significantly due to the impact of surging energy prices and a possible reduction in gas supply.

The terminal rate for November 2023, according to the short-term euro rate (ESTR) forward, was at around 1.2% from 2.6% hit in mid-June.

Nomura expects the ECB to raise rates by 175 basis points by March 2023. But as an expected recession drags on, they see a 25 basis-point rate cut to follow in June.

Germany's 10-year government bond yield fell 13 basis points (bps) to its lowest in almost a week at 1.179%. It hit its lowest since May 31 at 1.072% last week.

Money markets are currently pricing 137 bps of ECB rate hikes in 2022, down from 145 bps on Monday, and 180 bps worth of tightening by the end of 2023 from around 195 bps the day before.

"We see room for the Bund yields to decline to the bottom of the recent range," said Mohammed Kazmi, portfolio Manager at Union Bancaire Priv?e (UBP).

Peripheral bond prices -- which move inversely with yields -- slightly underperformed their peers on concerns about the ECB's so-called anti-fragmentation tool and Italian politics.

Italy's 10-year bond yield fell 10 bps to 3.202%, while the spread between Italian and German 10-year yields widened by 3.5 bps to 208 bps.

Portuguese and Spanish yield spreads widened by 2.5 and 3 bps to 107.5 and 108.3 bps.

GRAPHIC: Yield spreads

The ECB pledged to buy more bonds from debt-laden countries such as Italy to contain the widening spread between their borrowing costs and Germany's that might hamper monetary policy transmission across the bloc.

Hawkish policymaker Joachim Nagel said the ECB should model its bond-buying scheme on the one announced during the debt crisis, namely the Outright Monetary Transactions programme (OMT) which allows the ECB to buy unlimited amounts of bonds from countries that apply for a bailout from the European Stability Mechanism.

He added on Tuesday that current differences in yields were "fundamentally justified" until proven otherwise.

"Nagel's remarks don't help, but I don't think there's any real news about the anti-fragmentation tool. If markets were disappointed, we would see much higher spreads as markets would test the ECB's resolve," UBP's Kazmi argued.

Meanwhile, Italian Premier Mario Draghi met on Monday with Italy's president to discuss the future of his government amid simmering tensions with coalition member the 5-Star Movement.

"There's a bit of political noise affecting spreads with Five Star providing less support for the Draghi government. Our base-case scenario is that Draghi will stay as a prime minister, without snap elections this year," he added.