Euro zone yields drop on tumbling inflation, U.S. read-across

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By Alun John and Stefano Rebaudo

LONDON, Oct 31 (Reuters) - Euro zone yields fell on Tuesday as data showed inflation in the bloc dropped to its lowest in over two years, with bonds helped too by a rally in U.S. Treasuries.

Data that showed prices rose by just 2.9% in October, the slowest pace since July 2021, and the economy shrank 0.1% in the three months to September.

The two sets of data mean the ECB is almost certainly done with raising interest rates, but with a measure of inflation that excludes energy, food, alcohol and tobacco still at 4.2% - albeit its lowest level since July 2022 - the ECB is expected to keep rates high for a while, capping any hope of an imminent bond bounce back. Bond prices move inversely with yields.

Such a backdrop would explain the muted reaction to the lower-than-expected inflation data from Germany and Spain on Monday when the Bund yield ended less than one bp lower.

Germany's 10-year yield dropped 2.5 basis points (bps) on Tuesday to 2.77%, after falling 0.8 bps the day before.

Longer-dated U.S. Treasury yields dipped on Tuesday before the Federal Reserve on Wednesday is expected to conclude its two-day meeting by holding interest rates steady.

"The easy part of the (euro area) disinflation process, where base effects from last year’s surge in prices pushed down year-on-year inflation rates this year, is now likely played out," said Salomon Fiedler in an emailed comment.

"But as inflation will likely remain above its 2% target throughout next year due to elevated wage gains, we also see no cuts to money market rates forthcoming in 2024," he added.

ECB Vincenzo Visco, seen as a dove on the ECB's governing council, said orientation to keep rates at current levels for a sufficiently long period of time was "a wise decision."

Nomura expects the ECB to begin its cutting cycle in September 2024 as "the ECB is likely to continue to push back against market pricing of early cuts so long as services inflation, and underlying momentum in services inflation, remains strong."

ECB’s Yannis Stournaras said he would consider an interest rate cut should inflation sustainably fall below the 3% threshold in mid-2024.

"The ECB needs to see wage inflation slowing and this could take a further six months," said Deutsche Bank Research Chief European Economist Mark Wall in emailed comments.

However, money markets showed a different picture as they price in rate cuts for almost 50 bps by around mid-2024.

July 2024 ECB euro short-term rate forwards were at 3.44%, implying expectations for an ECB deposit facility rate of 3.54%, from the current 4%.

Italy's 10-year yield was down 2.5 bps at 4.71%.

The spread between Italian and German 10-year yields - a gauge of the risk premium investors ask to hold debt of the euro zone's most indebted countries - remained at 190 bps, its tightest level since early October.

The Italian government aims to place an increasing proportion of the public debt in domestic hands, Economy Minister Giancarlo Giorgetti said on Tuesday.

The strong orders from retail investors propped up demand for Italian bonds this year. (Reporting by Alun John and Stefano Rebaudo; Editing by John Stonestreet, Mark Potter and Angus MacSwan)