Euro zone bond yields drop as investors see less tightening

(Reuters) - Euro zone government bond yields fell on Tuesday amid expectations that the European Central Bank (ECB) might take a more cautious policy stance.

Concerns about a further economic slowdown and potential systemic risks, due to the impact of higher rates on most indebted countries, triggered a correction on terminal rate bets since the release of euro area inflation data last week.

Australia's central bank on Tuesday surprised markets by lifting interest rates by a smaller-than-expected 25 basis points, but added that further tightening would still be needed.

Germany's 10-year government bond yield, the bloc's benchmark, dropped 9 basis points (bps) to 1.80% after hitting its lowest since Sept. 19 at 1.77%. It reached its highest since end-November 2011 on Tuesday last week at 2.352%.

"The sight of a bond rally when investors smell a whiff of a central bank pivot is something to behold," ING analysts said in a research note.

"The root cause of the recent re-pricing lower in rates can be traced back to two factors: the global economic slowdown and resurgent fears for financial stability," they added.

The ECB's euro short-term rate (ESTR) forward for November 2023 was at around 2.5%, after rising above 3% to 3.158% on Tuesday last week.

Analysts also flagged that financial markets are signalling that the ECB might be on top of surging inflation.

A key market gauge of long-term inflation expectations rose to 2.09%, not far off its lowest since end-July hit on Monday at 2.06%.

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Dutch and British wholesale gas prices -- seen as a proxy of future inflation -- fell on Tuesday morning due to weaker demand and robust Norwegian and liquefied natural gas (LNG) supply.

Euro zone producer prices jumped slightly more than expected in August.

Yields on British gilts were falling, but analysts expect UK bonds to remain under pressure, as the government still wants to increase public spending to spur economic growth. However, they see orderly moves as the Bank of England is ready to step in.

British Prime Minister Liz Truss said it was the right time to take on some extra borrowing, adding that the country had a low debt to gross domestic product ratio.

Yields in British gilts were down, with the 10-year falling 16 bps to 3.78%. It was around 3.3% the day before the announcement of the UK fiscal plan.

(Reporting by Stefano Rebaudo, editing by Ed Osmond)

By Stefano Rebaudo