Markets boost bets on ECB rate cuts on weak data, tariff fears

By Stefano Rebaudo

March 28 (Reuters) - Money markets increased their bets on European Central Bank easing, with short-dated yields dropping to levels last seen before Germany announced its biggest ever spending package, as investors shifted focus to U.S. tariffs and weak economic data.

Inflation in March came in far below forecasts in two of the euro zone's largest economies.

Money markets priced in an 80% chance of a 25 basis points ECB rate cut in April from around 50% a week ago and a depo rate at 1.9% from around 1.95% late on Thursday.

German 2-year yield DE2YT=RR, more sensitive to the ECB policy rates, dropped 4 bps to 2.024%, its lowest level since March 4.

On March 5, German parties reached an agreement for a massive ramp-up in fiscal spending on infrastructure and defence investment, leading to the biggest rise in German long-dated yields in decades.

"It seems likely that the ECB will conclude that the downside risks from escalating trade tensions are materialising," said Christoph Rieger, head of rates and credit research at Commerzbank, referring to the impact of tariffs on the central bank policy path.

The euro area's benchmark Bund yield DE10YT=RR hit 2.708%, its lowest since March 5, and was last down 4.5 bps at 2.73%.

More weak economic data, including inflation and jobs figures, supported Friday’s drop in euro area bond yields.

The number of people out of work in Germany rose in March at the fastest rate since October of 2024, while morale among Italian businesses and consumers slumped in March.

German consumer sentiment was broadly unchanged, with a focus on saving highlighting uncertainty among households.

"The confidence boost that German businesses had after the elections and the fiscal U-turn which followed has not been entirely embraced by consumers," said Carsten Brzeski, global head of macro at ING.

"Looking ahead, the gradual weakening of the labour market looks set to continue," he added.

Italy's 10-year yields fell 3 bps to 3.85%. The yield gap between Italian BTPs and German Bunds DE10IT10=RR - a gauge of the risk premium investors ask to hold Italian debt - rose to 110.5 bps, its highest since January.

Citi flagged that "the tightening of BTP-Bund spread, even as Bund swap spreads richen, might be short-lived due to growth implications of tariffs and already tight spread levels."

The yield gap between French and German bonds DE10FR10=RR stood at 69.5 bps, at the lower end of its recent range.

Analysts argued that French OATs faced a return of political risk starting next week that might determine whether early elections are called after July.

Marine Le Pen, leader of France's far-right National Rally (RN) party, will on Monday learn her fate in an embezzlement trial that could upend French politics if she is barred from running in the 2027 presidential election.

"We expect the spread between OAT and Bunds to remain supported as we don't think a rating downgrade will materialise in the next weeks," said Sphia Salim, head of European rate strategy at BofA.

"It could widen to 80 bps in the second half of the year due to political uncertainty and because in the process of a rating downgrade to single-A, which remains likely, there will have to be a rebalancing of the investor base."