Euro area yields drop as Powell says Fed will support labour market

Euro zone government bond yields dropped and were set to end the week lower after Federal Reserve Chair Jerome Powell said on Friday the US central bank would support a strong labour market.

Powell offered an endorsement of an imminent policy easing, adding that further cooling in the job market would be unwelcome.

Markets slightly increased their bets on future Fed rate cuts, pricing in 102 basis points (bps) by year-end from 97 bps FEDWATCH before the Powell speech.

Germany's 10-year government bond yield dropped 2 bps to 2.22 per cent. It was up 1.5 bps at 2.26 per cent before Powell spoke. It was on track for ending the week 3.5 bps lower.

"They don't want further weakness so another rise in unemployment to 4.4 per cent or 4.5 per cent could trigger a 50 bps move (by the Fed)," said James Knightley, chief economist US at ING.

Markets discounted 33 bps in September, fully pricing a 25 bps Fed cut and a 30 per cent chance of a 50 bps reduction. FEDWATCH

They priced in around 70 bps of European Central Bank rate cuts by year-end from 65 bps before Powell.

A growing number of ECB policymakers are lining up behind another rate cut in September and only major data surprises in the coming weeks could delay the move, on and off record conversations with seven sources indicate.

Euro zone consumers' inflation expectations over the next 12 months remained steady for the third month in July, an ECB survey showed on Friday.

Italy's 10-year government bond yield, the benchmark for the euro area's periphery, dropped 5 bps to 3.56 per cent, with the yield spread with its German peers tightening to 133 bps.

The gap between German and French borrowing costs – a gauge of the risk premium investors demand to hold France's government bonds – was 70 bps. It hit 88 bps in early August, its highest since 2012, and reached 85 bps during French elections.

Markets are closely watching political developments in France as President Emmanuel Macron faces tough challenges.

Parliamentary approval of the 2025 budget is one of many tests at a time when France is under pressure from the European Commission and bond markets to reduce its deficit.

Macron began meeting party leaders on Friday with the aim, nearly seven weeks after inconclusive parliamentary elections, to finally give the country a new prime minister.

Investors were also assessing the impact of Thursday's economic figures as borrowing costs snapped a four-day falling streak on Thursday after euro area economic data.

Analysts said the positive impact of the Paris Olympic Games on French service sector sentiment, which rose by 4.9 points to 55.0, was a key – and likely temporary – driver of the positive surprise in the euro area PMIs.

Euro zone negotiated wage growth slowed in the second quarter, primarily because of a major slowdown in Germany.

"For the third quarter, this index (a Citi wage tracker) suggests a sharp re-acceleration in German negotiated wages growth from 3.4 per cent back to 5.7 per cent, mainly due to a 1000 euros one-off payment in the wholesale sector in August," said Christian Schulz European economist at Citi.

He argued that the second quarter decline was entirely due to drop in German wage growth, which was driven by volatile one-off payments.