Euro zone yields rise with fiscal policy in focus after US downgrade

By Stefano Rebaudo

May 19 (Reuters) - Euro zone government bond yields edged up on Monday, taking the lead from U.S. Treasuries as a Moody's downgrade of the U.S. credit rating underlined concerns about future fiscal policies.

The rating agency move could complicate President Donald Trump's efforts to cut taxes.

However, Treasury Secretary Scott Bessent on Sunday dismissed Moody's downgrade, saying the Trump administration would ensure U.S. economic growth outpaced its debt.

Germany's 10-year yield DE10YT=RR, the euro zone benchmark, rose 5.5 basis points (bps) to 2.64%. It hit 2.70% last week, its highest level since April 10.

Moody's move on the U.S. drew investors' attention to the expected growing public debt also across the euro area.

Germany approved a massive fiscal stimulus to fund defence and infrastructure spending, while markets expect some form of debt mutualisation at the European Union level for other countries' military investments.

The ECB may need to cut interest rates to "slightly below" 2% as the euro zone might be exposed to an adverse tariff-induced economic shock in the short term followed by a positive shock in 2026 and 2027, Belgian central bank governor Pierre Wunsch told the Financial Times in a weekend interview.

Money markets priced in a European Central Bank deposit facility rate of 1.75% by year-end EURESTECBM5X6=ICAP, roughly unchanged from late Friday.

"While Moody's is catching up with other rating agencies, the downgrade serves as a reminder of the mounting fiscal challenges, and could exacerbate the steepening bias in U.S. Treasuries ahead of this week's 20-year auction," said Hauke Siemssen, rate strategist at Commerzbank.

Rating agencies Fitch and S&P Global had downgraded the United States much earlier.

The global fiscal policy will be in focus during the G7 meeting of finance ministers and central bank governors in Banff, Canada, later this week.

U.S. Treasury yields rose in London trade, with the 10-year US10YT=RR up 10 bps at 4.54% after dropping 1.5 bps on Friday.

U.S. President Donald Trump's sweeping tax-cut bill won approval from a key congressional committee on Sunday. The measure would extend Trump's 2017 tax cuts, boost defence spending and provide more funds for his immigration crackdown.

Analysts said the tax bill talks would translate into upward pressure on U.S. Treasury yields.

Mark Haefele, chief investment officer at UBS Global Wealth Management, flagged that most investment mandates do not require AAA ratings for U.S. Treasuries, and central banks continue to value the Treasury market for its exceptionally deep liquidity.

"We would also expect the Federal Reserve to step in if there were a disorderly or unsustainable increase in bond yields," he argued.

German two-year yields DE2YT=RR, more sensitive to ECB policy rates, rose 3 bps to 1.88%.

Italy's 10-year yield rose 7.5 bps to 3.68% IT10YT=RR. The spread between Italian and German yields – a market gauge of the risk premium investors demand to hold Italian debt – was at 101 bps DE10IT10=RR, after narrowing to its tightest since April 2021 at around 94 bps last week.