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Euro zone short-dated yields just off multi-year highs ahead of Fed

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Euro zone government bond yields edged higher on Monday as investors braced for the outcome of the Federal Reserve policy meeting this week, after pricing in further monetary tightening despite increasing recession risks.

The European Central Bank could raise interest rates next year, causing pain for consumers as it tries to depress demand that is increasingly adding to sky-high inflation, chief economist Philip Lane said on Saturday.

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The Fed is widely expected to raise rates by 75 basis points, but some traders are betting on a 100 basis points increase, according to CME Group’s FedWatch tool. Money markets see a 20% chance of a full-point hike.

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The Bank of Japan and the Bank of England are also meeting this week.

Germany’s 10-year yield, the benchmark of the bloc, rose 0.5 basis points (bps) to 1.77%%, after hitting its highest since mid-June at 1.817% last week.

Germany’s 2-year yield, more sensitive to rate hikes, was flat at 1.55%, after hitting a new 11-year high at 1.62% last Friday.

“While ECB terminal rate expectations are already flirting with 2.75% by May, the short-end looks set to remain under pressure with ECB members suggesting that a mild recession will not stand in the way of several more major tightening steps,” Commerzbank analysts said in a note to clients.

Analysts said a so-called curve flattening bias remained intact. A flattening or inverted yield curve – namely, when long-dated yields are equal to or lower than short-dated ones — signals investors’ caution about the economic outlook.

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It also suggests a central bank reaction to rising inflation may be seen as a hawkish mistake that could stifle growth.

The gap between 2- and 10-year German yields was at 20.3 bps, after hitting its tightest since January 2021 at 16.3 last week.

Italy’s 10-year government bond yield rose 1.5 bps to 4.04%, with the spread between Italian and German 10-year yields at around 227 bps ahead of general elections due on Sept. 25.

The absence of anti-euro rhetoric seen in the 2018 election has reassured investors, for now. But pressure on bonds could build as focus shifts to budget policy in 2023, and concerns arise about a potential clash with the EU if right-wing parties push for fewer taxes and higher pension spending. (Reporting by Stefano Rebaudo, editing by Ed Osmond)

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