July 27 (Reuters) - Euro zone yields edged lower on Thursday ahead of the European Central Bank policy meeting later in the day and after remarks from Federal Reserve chair Jerome Powell supported market expectations that the tightening cycle might be close to an end.
The Fed raised rates by a quarter of a percentage point on Wednesday, and Powell said the economy still needed to slow and the labour market to weaken for inflation to "credibly" return to the U.S. central bank's 2% target.
Analysts expect the ECB to hike rates by 25 bps and President Christine Lagarde to provide "purely data-driven guidance" -- which means not mentioning that more tightening is needed -- or to stress conditionality and uncertainty in comments about future policy.
Such a scenario might lower yields as market bets imply a rate cut in the first half of next year. For this reason, the central bank will be keen to avoid delivering dovish remarks, which could lead to an easing of financial conditions.
Money markets keep pricing a terminal rate just below 4%, with December 2023 ECB euro short-term rate forwards at 3.86%, implying expectations for a depo rate at 3.96% by year-end. They price an around 50% chance of a 25 basis points rate hike in September. The depo rate is currently at 3.5%.
"The ECB is highly likely to mirror the Fed move last night in hiking 25bp but leaving September completely open, subject to incoming data," said Jamie Searle, European rates strategist at Citi, in a research note.
"Still, the market is bound to search for nuance, although the country-level flash inflation data tomorrow may well provide a greater steer," he added.
Germany, France and Spain will issue consumer price data which might provide clues about whether the inflation trend would lead the ECB to pause the hiking cycle in September.
Germany's 10-year government bond yield, the euro area's benchmark, fell 0.5 bps to 2.45%, not far from the middle of the range of the last few months.
It reached on July 10 2.679%, its highest level since mid-March, after remaining above 2.2% since April.
U.S. Treasury yields rose, with the 10-year up 1.5 basis points (bps). They slid on Wednesday in choppy trading after the Fed left the door open for another rate increase, which market participants saw as unlikely.
Investors will also monitor yield spreads between the core and periphery, which have been flat recently after tightening for most of this year.
They expect the ECB not to change its guidance about reinvesting the principal payments from maturing securities purchased under the Pandemic Emergency Purchase Programme (PEPP) until at least the end of 2024.
However, in the tail-risk scenario of the ECB mentioning PEPP quantitative tightening as a potential option, they expect widening pressures on spreads, mainly Italy, as they are the primary beneficiary of the PEPP-safety net.
The central bank deemed these reinvestments the first line of defence against an excessive widening in yield spreads across the euro area, which might hamper the monetary policy transmission mechanism.
Italy's 10-year government bond yield dropped 1 bp to 4.10%, with the spread between Italian and German 10-year yields at 164.5 bps. (Reporting by Stefano Rebaudo; Editing by Toby Chopra and Bernadette Baum)
