Euro zone government bonds fell slightly on Friday in a choppy session as a rise in the euro and a rally in stock markets gave investors conflicting trading cues. Providing a positive backdrop for government debt, the euro hit two-year highs against the dollar.
Moving as high as $1.3637, raising doubts over how much higher euro zone interest rates will be raised this year. Less encouraging for bonds, however, was the rally in euro zone stocks to six-year highs as frenzied merger and acquisition speculation encouraged investors to shift into riskier assets.
Despite the slight dip, Bunds were on track for their first weekly rise in five weeks. "We have seen sideways trading but I think underlying sentiment is still fairly bearish on the bond market," said Bob Maes, an interest rate strategist at KBC.
"With 10-year yields still below their year high, there is plenty of upside potential for yields. This has a lot to do with growth prospects in the euro zone improving." At 1526 GMT, the June Bund future was down 9 ticks at 113.73 compared with the previous session's settlement close, while the 10-year Bund yield was virtually unchanged at 4.20 percent.
The 2-year Schatz yield was also steady at 4.134 percent. The market was however poised for its first weekly gain in five weeks, with 10-year yields hovering below last Friday's levels as the euro has risen and following tame US inflation data earlier in the week.
EURO IN FOCUS: Investors are closely monitoring developments in currency markets amid speculation the euro could hit new peaks as high as $1.40, potentially slowing the pace of monetary tightening in the euro zone.
But strategists said although a spike in the currency would typically dampen imported inflation and hit export growth in the region, the unit's recent gains are unlikely to stop the European Central Bank raising rates again this year.
"It is not expected that the ECB will end its tightening soon because of the euro appreciation, even though the euro appreciation is tightening monetary conditions," said Unicredit analyst Marco Kramer. "Since the economic sentiment indicators and the key liquidity numbers at the beginning of the year were higher than expected, the ECB remains clearly on course." Unicredit expects base rates to rise by a further 50 basis points to 4.50 percent by year-end.
Financial markets are fully pricing in a hike to 4 percent by June and around a 50-50 chance of an additional hike to 4.25 percent in the second half of the year.
Comments from ECB Governing Council member Axel Weber on Friday reinforced the view that the central bank is not done raising rates. In a newspaper interview, he said inflation risks exist in the medium term and the ECB must act against them.
ECB executive board member Jose Manuel Gonzalez-Paramo said late on Thursday that ECB policy remained accommodative, and the euro's strength was not a cause for concern.
Euro zone central bankers and finance ministers, in Berlin for a two-day informal meeting, renewed attempts to curb the euro's rise against the dollar and yen, with ECB President Jean-Claude Trichet warning traders they could get burned betting one way. The spread between US and euro zone bond yields, meanwhile, widened back in the dollar's favour by around 3 basis points on Friday, rebounding from a two and a half year low of 46 basis points on Thursday.
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