Euro zone bond yields back off multi-year highs ahead of U.S. data

Euro zone borrowing costs fell on Thursday as investors paused for breath ahead of key U.S. economic data after driving government bond yields to fresh multi-year highs.

Data on Wednesday showed U.S. producer prices increased more than expected in September, but underlying goods prices posted their weakest reading in nearly 2-1/2 years.[nL1N31D10Z]

That saw markets repricing some of their inflation expectations ahead of U.S. consumer inflation data later in the session (1230 GMT).

A key market gauge of long-term inflation expectations was at its highest since May at 2.3%, while forwards on euro short-term rates (ESTR) are now peaking in November 2023 at around 3%.

"We think (policy) rates are unlikely to go close to 3% next year," Dean Turner, an economist at UBS Wealth Management said, adding UBS is forecasting 125 basis points (bps) of rate hikes by December.

"The euro area may be in recession through the winter months, and that's going to be one of the factors softening the ECB policy stance."

Germany's 10-year government bond yield, the benchmark of the bloc, fell 6 bps to 2.28% after hitting its highest since August 2011 at 2.423% on Wednesday.

Concerns about stability in the UK gilt market weighed on bond prices after the Bank of England (BoE) governor told pension funds they had until Friday to fix liquidity problems before the bank withdraws support.

However, most analysts expect the BoE's emergency bond buybacks to be extended.

"If we get another episode where liquidity dries up, the BoE may have to return to the market," UBS' Turner argued. "It's not a matter of yield levels, but they need the UK market to function orderly."

U.S. consumer price numbers due later on Thursday will be the last before the November Federal Reserve policy meeting.

Analysts said that, while the Fed was unlikely to shift from a 75 bps hike, any signs that inflation is yet to peak might fuel further hawkish rhetoric.

"Today's U.S. CPI figures should provide little relief," Commerzbank analysts said. "A marginal decline in the headline rate should be cold comfort at levels still above 8% and core inflation is likely to accelerate further."

ECB President Christine Lagarde said on Wednesday a debate about mopping up excess cash - quantitative tightening (QT) -- got underway.

ECB's hawk Klaas Knot said on Wednesday two rate hikes would take the ECB to the so-called neutral rate, but the bank needs to go into restrictive territory.

Italy's 10-year government bond yield fell 12 bps to 4.67%. It hit its highest since February 2013 at 4.927% on Sept. 28. The spread between Italian and German 10-year yields was at 238 bps.