Euro zone bond yields dip as inflation hits ECB target, central banks in focus

By Samuel Indyk

LONDON, July 1 (Reuters) - Euro zone government bond yields fell slightly on Tuesday but remained within their recent range as inflation in the bloc returned to the European Central Bank's target level.

Inflation in the 20 nations sharing the euro currency crept up to 2.0% in June from 1.9% a month earlier, in line with expectations in a Reuters poll of economists.

Germany's 10-year bond yield DE10YT=RR, the benchmark for the euro area, was last down 2.4 basis points at 2.573%. The trading range for Bund yields during June was the narrowest since 2021, according to Commerzbank.

The ECB, having lowered borrowing costs eight times since the middle of last year, has recently signalled it intends to pause rate cuts with inflation back at target.

"They (the ECB) seem to be happy with policy for the time being," said Jussi Hiljanen, chief rates strategist at SEB.

"The broad consensus is that the right thing to do in July is wait and see and then look at the situation in September when they have revised economic projections."

Money market traders are pricing in just a 5% chance of a rate cut this month. Futures are pricing 26 basis points of easing by the end of the year, implying one more quarter-point rate cut.

German two-year yields DE2YT=RR, the most sensitive to expectations for monetary policy, were down 1 bp at 1.849%.

Euro zone yields partially reversed an earlier decline after U.S. Treasury yields edged up following comments from Federal Reserve Chairman Jerome Powell, who said the central bank would wait for more data before cutting U.S. rates US10YT=RR.

"We're simply taking some time," Powell said at the ECB Forum on Central Banking in Sintra, Portugal. This was a day after Trump sent him a handwritten missive noting how low other central banks had cut rates and suggesting the U.S. needed to move.

ECB President Christine Lagarde on Tuesday said the euro zone was set to face increasing inflation volatility.

Investors have recently increased their bets on easing from the Fed, given soft data and as U.S. President Donald Trump has upped his pressure on Powell to lower interest rates.

The repricing of Fed interest rate expectations was having an impact on euro zone bond yields, analysts said.

Italy's 10-year bond yield IT10YT=RR was down 1.4 bps at 3.479%, leaving the gap between Italian and German 10-year yields DE10IT10=RR at 89.8 bps.

The spread has narrowed significantly in recent months and is close to its tightest in more than a decade.

"It's a pretty amazing development," SEB's Hiljanen said.

"The generally positive risk appetite is having a positive impact for spreads."

Attention remained on the U.S., where Senate Republicans were pushing to pass President Donald Trump's sweeping tax-cut and spending bill that is set to add an expected $3.3 trillion to the nation's debt pile.

Fiscal sustainability of the world's major economies has been a key theme in recent weeks, as Germany recently approved its draft budget for 2025 and a budget framework for 2026 including record investment to revive the economy.

Meanwhile, NATO members agreed to boost defence spending to 5% of gross domestic product, broadly defined, with deficits already ballooning in nations such as France and Britain.

"While the fiscal expansion in Europe appears in the price, the market is not giving due credit to the fiscal picture in the U.S.," said Jefferies economist Mohit Kumar.

"Our view remains that H2 will see a lot of focus on fiscal expansion which would put upward pressure on rates."