Short-end euro zone bond yields pull back on ECB currency concerns

By Samuel Indyk

Jan 28 (Reuters) - Short-end euro zone bond yields fell slightly on Wednesday after European Central Bank policymakers flagged that recent euro appreciation could start to have an effect on inflation and the path of interest rates.

The euro zone is a net energy importer, so even slight currency appreciation can significantly lower the price of energy and other imported goods, which could push inflation down.

Austrian central bank governor Martin Kocher said in an interview with the Financial Times that the euro's gains so far were "modest" and did not yet require a response, but if sharper appreciation lowered inflation projections then it might be time to think about cutting rates.

Fellow policymaker Francois Villeroy de Galhau, of France, said the ECB was closely monitoring the currency and possible consequences for lower inflation.

Other central bank officials sounded more cautious, however. ECB policymaker Gediminas Simkus told Econostream Media that it would be an "oversimplification" to say policy needed to be adjusted because the euro was at a certain level, noting that the currency could pull back again.

RATE CUT BETS

Markets slightly added to bets on an ECB rate cut by the summer following the comments. Futures imply about a 22% chance of a rate cut by July, from around 15% on Tuesday EURESTECBM5X6=ICAP.

Germany's 2-year bond yield DE2YT=RR, which is sensitive to changes in ECB rate expectations, was last down by 2 basis points to 2.0806%, after touching its lowest level in a week earlier in the session.

DZ Bank analyst Rene Albrecht already expects euro zone inflation to drop below 2% in the first and second quarters of this year due to base effects from higher energy prices dropping out of the annual calculation.

"If you add another layer of deflationary impulses from the exchange rate, we can make a case that the ECB might cut once or twice," Albrecht said, although he noted that the euro would need to strengthen further for that to be the case.

The euro EUR=EBS has strengthened sharply against the dollar in recent days, rising above $1.20 on Tuesday after U.S. President Donald Trump said the value of the dollar was "great". It was last at $1.1942 against the dollar.

The dollar index =USD, which measures the currency against six peers including the euro, hovered near a four-year low.

SPREAD BETWEEN GERMAN AND FRENCH BENCHMARKS TIGHTENS

Germany's 10-year yield DE10YT=RR, the benchmark for the euro zone, was down 1 bp at 2.8611%.

France's 10-year yield FR10YT=RR dropped less than 1 bp. Earlier on Wednesday, the spread between German and French 10-year yields DE10FR10=RR touched 55.15 bps, its tightest level since French President Emmanuel Macron called a snap election in June 2024. It was last at around 56 bps.

The spread has been tightening sharply in the last two weeks after the French government said it would use constitutional powers to pass a budget for 2026.

"The story has run its course now and it won't tighten that much anymore," DZ Bank's Albrecht said.

"Our view is that the spread should stick to a range between 55 and 65 basis points for the foreseeable future, since they don't get their deficit down and it's almost certain they won't in 2027."

Investors were looking ahead to the Federal Reserve rate decision later on Wednesday. Analysts and economists widely expect the central bank to keep the Fed funds rate unchanged, after a cut in December to a range of 3.5%-3.75%.

Markets are fully pricing in the next rate cut in July, with almost two quarter-point moves priced in by the end of the year.