One Euro coins are seen in this illustration
One Euro coins are seen in this illustration taken November 9, 2021. Reuters

Euro zone government bond yields rose on Wednesday, but stayed well below multi-year highs, as concerns about systemic risks and economic slowdown led investors to lower bets on where interest rates might peak.

But the prospect of less aggressive monetary policy is likely to fade if inflation keeps surprising on the upside and the economy shows some strength.

A sharp rate rise in New Zealand was a reminder that central banks remain in monetary tightening mode.

Germany's 10-year bond yield, the euro zone benchmark, rose 4 basis points (bps) to 1.93%.

It reached its highest since November 2011 on Tuesday last week at 2.35%.

"The bond rally will need another relay of 'good', understand 'bad' from the point of view of the economy, news to keep its momentum going," ING analysts said.

Investors will now focus on U.S jobs report due on Friday.

"Slower growth in payrolls and wages, or a rise in the unemployment rate, could further fuel positive sentiment regarding Fed policy," said Mark Haefele, chief investment officer at UBS Global Wealth Management.

He also mentioned that recent weaker JOLTS data has supported investors' perception that the Federal Reserve's actions are cooling the labour market, one of the preconditions for the Fed to pause rate hikes.

U.S private payrolls numbers for September were not far off consensus forecasts.

S&P Global's final composite Purchasing Managers' Index (PMI) for the euro zone confirmed that the drop in euro zone business activity deepened last month.

"While central banks are reiterating the importance of data dependency, one still has the impression that realised inflation is key, and with current levels of 10%, it is hard to believe European government bonds will continue their bull run over the next few days," UniCredit analysts said.

They also noted that market-based inflation expectations had fallen substantially.

A market gauge of long-term inflation expectations was at 2.16%, after hitting its lowest since the end of July on Monday at 2.06%.

Bond yields in the euro area have declined from their multi-year highs last week, while euro zone inflation data hit 10.0% in September, a record high.

Italy's 10-year government bond yield rose 12.5 bps to 4.315% on Wednesday, with the spread between Italian and German 10-year yields widening to 238 bps.

Analysts said subsiding quantitative tightening risks and talk about more European Union joint issuance supported yield spread tightening between core and peripheral bonds.

Two top EU officials on Tuesday called for joint borrowing to help the 27-nation bloc navigate the energy crunch, which would support heavily-indebted countries.

Some analysts quoted media sources saying the European Central Bank's governing council will begin discussions on shrinking its balance sheet during Wednesday's non-monetary policy meeting.