German yields pause above record lows before ECB decision

LONDON: Core government bond yields held above record lows on Thursday as dismal economic data this week prepared the ground for a key European Central policy meeting later, at which policymakers were widely expected to unveil plans for more stimulus.

Although a majority of economists in a Reuters poll expect a deposit rate cut only in September, weak PMI data on Wednesday raised pressure on ECB officials and sent core German bond yields deeper into negative territory.

"The weak macro data this week means the ECB will be forced to act sooner than later," said Daniel Lenz, a rates strategist at DZ Bank in Frankfurt.

On Thursday, yields on 10-year German government bonds  held at minus 42.6 basis points, a whisker above a record low of minus 43.3 bps hit on Wednesday and more than 2 bps below the ECB's deposit rate at minus 40 bps.

A stellar first half for bond markets in Europe got fresh legs after ECB President Mario Draghi's June speech in Sintra, Portugal, where he flagged downside risks to the eurozone economy had not increased over that period.

German yields are down by more than 70 bps since then, while yields in the peripheral economies such as Italy and Portugal are down by more than 100 bps over that period. The euro  has weakened by nearly 2% since then.

Data across the euro zone showed business growth has been much weaker than expected this month.

IHS Markit's Flash Composite Purchasing Managers' Index (PMI), considered a good guide to economic health, missed forecasts. The index dropped to 51.5 this month from a final June reading of 52.2, missing the median expectation in a Reuters poll for 52.1.

The weaker data could prompt a more dovish than expected response by the ECB at its July meeting, suggesting that rather than just changing forward guidance, policy action could be taken.

Money markets are now pricing in around a 50% chance of a 10-basis-point rate cut by the ECB at that meeting, while a 10 bps cut is fully priced in for September's meeting.

"Yesterday's PMI misses raise the risk that the ECB delivers easing ahead of schedule today, rather than providing a cutting bias to the forward guidance," Peter Chatwell, head of rates strategy at Mizuho said in a daily note.