Euro area markets scale back bets on rate hikes before ECB meeting

By Stefano Rebaudo

Dec 17 (Reuters) - Euro zone bond yields fell and investors pared back bets on future European Central Bank rate hikes on Wednesday as the impact of recent hawkish remarks by board member Isabel Schnabel faded ahead of Thursday's policy meeting.

Borrowing costs jumped early last week after Schnabel said the ECB's next move may be an interest rate hike, rather than a cut as some still expected.

Traders priced out a rate cut in summer 2026 and positioned for a hike in early 2027, as Schnabel’s remarks aligned with data pointing to a resilient euro zone economy and expectations that increased German fiscal spending will support growth from late 2026.

However, analysts cautioned that Schnabel’s stance may not reflect the broader ECB view, warning that a strong euro and aggressive Chinese trade policies could inject a deflationary impulse into the euro zone economy and push the central bank towards a more dovish stance.

Money markets priced in around a 15% probability of a tightening move by December 2026 and a 35% chance by March 2027 from over 50% last week. The ECB depo rate is currently at 2%.

“It is difficult to understand Schnabel's comments unless they are intended to cut the ground from under those who want to keep alive the debate on possible rate cuts,” said Bruno Cavalier, chief economist at Oddo.

“The new projections prepared by ECB staff for the meeting on 18 December will certainly not describe a European economy on the verge of overheating."

Yields on the German 2-year Schatz DE2YT=RR, which is more sensitive to expectations for policy rates, were flat in late trading at 2.139%, having earlier hit their lowest in about a week.

In November 2023, Schnabel said the last mile of disinflation might be the toughest. But inflation fell back below target in 2024 and will average 2.1% in 2025, Oddo’s Cavalier said. The ECB last hiked rates in September 2023.

Germany’s 10-year yields DE10YT=RR, the euro area’s benchmark, were up 1.5 basis points at 2.86%, after reaching their lowest since December 8 at 2.826%. They hit 2.894% last week, their highest since mid-March.

German business morale unexpectedly fell in December, a survey showed on Wednesday, as Europe's largest economy continues to struggle to grow.

Analysts remain sceptical about the boosting impact of German fiscal spending.

"We expect the boost from the fiscal stimulus to underwhelm," said Franziska Palmas, senior Europe economist at Capital Economics, after mentioning that part of the stimulus is set to be used to cover the rising fiscal cost of ageing.

German 30-year yields DE30YT=RR rose 1.2 bps to 3.48%. They hit 3.498% last week, the most since July 2011, as long-dated debt came under pressure on expectations of heavier bond supply.

The Bank of England will also be in focus on Thursday, and is expected to cut interest rates, while the Bank of Japan will announce its decision on Friday.

Benchmark 10-year U.S. Treasuries yields US10YT=RR rose 1 bp to 4.15% after falling 3.5 bps the day before following data that showed an unexpected increase in the unemployment rate last month.

Italy’s 10-year government bond yields IT10YT=RR were up 2.5 bps at 3.54%, with the gap versus Bunds at 67.2 bps, after having hit a new 16-year low at 64.5 bps.