Bond rally fizzles out, still set for third straight weekly gain

The sun sets behind the skyline of Frankfurt, Germany, August 30, 2022. REUTERS/Kai Pfaffenbach/File Photo

LONDON, Nov 25 (Reuters) - The recent rally in euro zone bonds came to a halt on Friday in thin trading conditions but yields were still set to end the week lower for a third straight week as central banks prepare to slow the pace of tightening.

Longer-dated global bond yields have dropped sharply in November as signs that inflation is cooling in the United States raised hopes the Federal Reserve could slow its rate hiking cycle, alleviating pressure on other central banks.

"We have seen a very, very strong rally in bond markets earlier this week… people are saying 'OK maybe this was a bit too much'," said Piet Haines Christiansen, chief analyst at Danske Bank.

"I think this move we have seen over the past couple of days is one of these FOMO - fear of missing out - rallies."

Markets were also focusing on comments from influential European Central Bank (ECB) policy maker Isabel Schnabel on Thursday, who pushed back against calls for smaller rate increases, saying this could hamper efforts to tame inflation.

Germany's 10-year yield was last up 13 basis points (bps) at 1.974%. For the week, it's fallen 4.5 bps.

Germany's two-year yield, which is most sensitive to ECB rate expectations, was up 8 basis points at 2.182%.

Meanwhile, Germany's yield curve briefly traded at its deepest inversion since 1992 on Friday, in a potentially worrying sign for Europe's biggest economy.

The gap between the 2-year and 10-year government bond yield fell to -27 basis points (bps) in early trade before rising to -21 bps. The drop to -27 bps was the widest gap since October 1992, Refinitiv data showed.

An inversion is uncommon and is seen by many economists as a precursor to a recession.

Christoph Rieger, head of rates and credit research at Commerzbank, said it was a sign that investors expected the ECB to pause its rate hikes or even cut them next year.

However, he added: "I think they'll continue raising rates more than the market and many people are predicting."

Markets are pricing in a peak in ECB interest rates of around 2.9% in the middle of 2023, according to Refinitiv data.

Rieger said the German curve has less predictive power than that of the United States, because it takes into account the diverse economies of the euro zone.

Strategists at Societe Generale said in their 2023 outlook on Thursday that they expected the German 10-year yield to shoot back higher and hit 2.5% in the first quarter.

They said that, although inflation was peaking in the United States, it was not yet slowing in Europe. SocGen predicted the ECB would hike rates to 3% by May 2023, from 1.5% currently, and keep them there until the end of 2024.

Italy's 10-year yield was up 21 bps to 3.889% on Friday, although was on track for its third straight weekly fall, having fallen 2 bps this week.

Reporting by Harry Robertson, additional reporting by Samuel Indyk; Editing by Barbara Lewis, Toby Chopra and Alex Richardson

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