Euro zone yields rise as fears of a banking crisis fade, await Fed

March 22 (Reuters) - Euro zone government bond yields rose on Wednesday as investors awaited the outcome of the Federal Reserve policy meeting, with fears of a banking crisis fading and European Central Bank (ECB) hawks calling for more rate hikes.

Bundesbank chief Joachim Nagel said policy-setters must be “stubborn” and continue increasing borrowing costs to battle inflation, according to an interview published on Wednesday

U.S. Treasury Secretary Janet Yellen told bankers on Tuesday she was prepared to intervene to protect depositors in smaller U.S. banks suffering deposit runs.

Germany’s 10-year government bond yield, the euro zone’s benchmark, rose 5 basis points (bps) to 2.33%. It hit its lowest level since mid-December at 1.923% on Monday after reaching its highest since July 2011 at 2.77% in early March.

The ECB interest rate increases are just starting to take effect on the economy, ECB President Christine Lagarde said.

The U.S. Fed’s Federal Open Market Committee (FOMC) announces its decision on interest rates at 1800 GMT.

Analysts expect a 25 bps rate hike and a measured approach by Chair Jerome Powell, with the post-meeting statement dropping the reference to hawkish remarks like “ongoing increases” in rates being appropriate.

They also see a greater risk of Fed rate hiking and balance sheet reduction ending sooner, and the outlook for any tightening depending on financial stability.

Germany’s 2-year government bond yield, most sensitive to changes in expectations for policy rates, rose 10 bps to 2.68%. It hit its lowest level since mid-December at 2.089% on Monday after reaching its highest since October 2008 at 3.385% in early March.

“It is still very early days, but inflation risk may be in the process of making a comeback as the primary duration driver versus financial risk,” said Aman Bansal, a European rates strategist at Citi.

Markets kept repricing to the upside the ECB’s future rate rises, with the peak in the deposit facility rate seen in September at around 3.5% after a drop to about 3.0% on fears of a banking crisis in Europe.

The September 2023 ECB euro short-term rate forward rose to 3.38%, implying a depo rate of 3.49%.

Market stress indicators were back to levels seen before fears of a banking crisis started weakening risk appetite.

The gap between two-year euro swap rates and two-year German bond yields was at 68 bps after reaching its highest since early November at 96.7 bps on Monday.

A spread widening is usually a result of strong demand for safe-haven bonds. The swap spread measures the premium on the fixed leg of an interest rate swap, used by investors to hedge against rate risk relative to bond yields.

Italy’s 10-year government bond yield rose 5 bps to 4.16%, with the closely watched spread between Italian and German 10-year yields at 182 bps. (Reporting by Stefano Rebaudo Editing by Mark Potter)