Euro zone yields fall on Middle East hopes, two ECB hikes priced in for 2026

By Stefano Rebaudo

May 25 (Reuters) - Euro zone government bond yields fell to their lowest levels in about a month on Monday as renewed hopes of a U.S.-Iran deal to reopen the Strait of Hormuz eased concerns over inflation and reduced expectations of aggressive central bank policy tightening. Borrowing costs tracked moves in oil prices, which slid 6% amid optimism over a resolution of the conflict, even as key sticking points remained unresolved.

This was despite Iran and the United States playing down hopes for an imminent breakthrough in efforts to end their war.

Money markets priced in a European Central Bank depo rate at 2.56% in December from 2.67% late Friday, from the current 2%. They indicated a 70% chance of a first rise next month from 80%.

"It is unclear whether by mid-June there will be enough clarity and certainty around any potential deal to call off a (ECB) rate hike," said Benjamin Schroeder, senior rate strategist at ING.

"There is good reason for caution around the need for further tightening," he argued.

ING's Schroeder noted Europe would benefit the most from a swift resolution to the disruption in the Strait of Hormuz, adding that the region's broader macroeconomic environment remains fragile. Germany's 2-year yields, more sensitive to expectations for policy rates, fell 10 basis points (bps) to 2.54%, their lowest since May 7. They reached 2.771% in late March, the highest since July 2024. ECB policymaker Yiannis Stournaras said on Monday that if euro zone inflation overshoots the target temporarily but significantly, there should be a cautious adjustment of monetary policy in a more restrictive direction.

"The second-order effect of oil and inflation is showing up in sovereign bond markets," Bob Savage, head of markets macro strategy at BNY, said.

"The question for investors is what drives bond yields beyond oil, with focus on central bank policy, fiscal sustainability and whether growth can support the debt load," he added, after recalling the recent rise in long-dated government bond yields globally. Germany's 10-year government bond yield, the euro area's benchmark, was down 9 bps at 2.9831%, its lowest since April 8. It reached 3.13% in late March, its highest level since June 2011. Italy's 10-year government bond yield fell 6.5 bps to 3.657%, its lowest since April 17. The yield gap of Italian government bonds versus Bunds was at 71 bps. It was at 63 bps before the attack on Iran and hit 103.62 in late March, the highest level since June 2025. (Reporting by Stefano Rebaudo; Editing by Bernadette Baum and Toby Chopra)