Euro zone yields rise as markets weigh impact of China protests

By Samuel Indyk

(Reuters) -Euro zone government bond yields were higher on Monday after rare protests in China over the country’s strict zero-COVID policies clouded the outlook for global growth and inflation.

Hundreds of demonstrators in Shanghai and other major cities shouted and jostled with police on Sunday evening as protests flared for a third day following a deadly apartment fire in the country’s far west.

“This could be negative for economic growth and add to inflationary pressures,” said Daniel Lenz, rates strategist at DZ Bank, citing the risk that supply chains could be negatively affected if China introduces stricter lockdowns to slow COVID-19 outbreaks.

“The market is more concerned about the impact on inflation than the impact on growth,” he added.

Germany’s 10-year government bond yield was up 2 basis points (bps) at 1.99%, after rising 12 bps on Friday.

Germany’s two-year yield, the most sensitive to changes in interest rate expectations, was little changed at 2.182%.

Meanwhile, investors were watching for comments from European Central Bank policymakers after board member Isabel Schnabel pushed back on Thursday against calls from many of her colleagues for smaller interest rate increases.

ECB president Christine Lagarde on Thursday kept her options open as to the size and number of future rate hikes, saying this would depend on a number of variables.

“How much further we need to go, and how fast we need to get there, will be based on our updated outlook, the persistence of the shocks, the reaction of wages and inflation expectations, and on our assessment of the transmission of our policy stance,” Lagarde told the European Parliament.

Markets are fully pricing in a 50-basis-point hike at the ECB’s December meeting and around a 60% chance of a larger 75 basis point rate rise, according to data from Refinitiv.

Germany’s yield curve steepened after hitting its deepest inversion since 1992 last week.

The gap between the 2-year and 10-year government bond yields rose to -19 bps. It hit -27.1 bps, the widest negative gap since October 1992 late on Thursday, Refinitiv data showed.

Analysts said an inversion suggested that investors expect the ECB to pause its rate hikes or even cut rates next year if inflation starts declining faster than expected or if the central bank focuses on avoiding a deep recession.

Italy’s 10-year yield rose 7 bps to 3.923% pushing the closely watched spread between Italian and German 10-year yields wider by 6 bps to 193 bps.

“In this environment, an equilibrium for the spread would be around 200 basis points,” DZ Bank’s Lenz said.

“At levels below this, markets see this as an area good for profit taking,” Lenz added.

The spread narrowed to around 180 basis points on Friday, its tightest since April.

(Reporting by Samuel Indyk and Stefano Rebaudo; editing by Conor Humphries and Bernadette Baum)