UPDATE 2-Euro zone yields slip after U.S. inflation cools

·3 min read

(Adds U.S. PCE data, updates prices)

By Amanda Cooper and Harry Robertson

LONDON, March 31 (Reuters) - Euro zone government bond yields slipped on Friday as investors focused on falls in U.S. and European inflation, while fears of a full-blown banking crisis continued to recede.

Euro zone inflation dropped by the most on record in March, preliminary data on Friday showed. However, an acceleration in core price pressures, which exclude food and energy, is likely to trouble European Central Bank (ECB) policymakers.

Separate data showed U.S. personal consumption expenditures inflation - the Federal Reserve's preferred price gauge - fell in February, with the core reading lower than expected.

Two-year German Schatz yields, the most sensitive to shifts in expectations for interest rates, fell after the U.S. data and were last down 3 bps at 2.713%.

Despite Friday's slight fall, they are up 34 bps this week.

The rise has been driven largely by proof that regulators, central banks and governments on both sides of the Atlantic are committed to preventing the spread of any problems at smaller lenders to the wider financial system.

This has boosted equities and delivered a blow to safe-haven assets like government bonds.

However, now the worst of the banking turmoil appears to have been contained for the time being, investors are taking another look at the inflation outlook and what that might mean for rates.

"The inflation story is still not very comfortable, whether here in Europe or in the U.S. This morning's inflation data reinforces that message," Daiwa Capital senior economist Chris Scicluna said. "We’re still looking at further tightening from ECB," he added.

A market-based gauge of long-term inflation expectations eased to 2.42% from 2.45% prior to the data, but this was still around its highest for two weeks.

Benchmark German Bund yields were down 3 bps at 2.333%, leaving the discount to two-year yields at -38 bps.

"The outlook for the European Central Bank is more uncertain, with risks of a higher terminal (peak) rate," said Daniele Antonucci, chief economist and macro strategist at Quintet Private Bank.

"Short-term interest rates remain higher than long-term ones, a sign that investors are concerned about growth."

Friday's preliminary data showed that euro zone inflation cooled to 6.9% year-on-year in March, down from 8.5% in February. Core inflation rose to a record high of 5.7%, however, from 5.6%.

In the U.S., PCE inflation fell to 5% in February from 5.4% in January. The core reading cooled more than expected to 4.6%, from 4.7% in January.

The slowdown caused a dip in U.S. bond yields, with the 10-year U.S. Treasury yield last down 2 bps at 3.534%.

In terms of ECB expectations, interest rate derivatives show traders expect rates to peak around 3.65% by November this year.

This marks a stark contrast with the beginning of the month, when money markets showed the expectation was for rates to continue to rise into early next year and peak above 4%.

The ECB has already raised interest rates by 350 bps since last year, taking them to 3%.

"People will have to see what effect that tightening has on growth going forward in due course," Daiwa's Scicluna said.

Italian 10-year yields eased 7 bps to 4.152%, bringing their premium to Bunds to 181 bps.

The spread was around 172 bps at the start of the month, highlighting how far German debt yields have dropped relative to others these past few weeks.

(Reporting by Amanda Cooper and Harry Robertson; Additional reporting by Nell Mackenzie; Editing by Mark Potter, Robert Birsel and Alexander Smith)