UPDATE 2-Euro zone bond yields fall on fresh financial stability jitters

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March 24 (Reuters) - Euro zone government bond yields fell on Friday, with investors betting on fewer rate hikes from the European Central Bank, while renewed banking stability concerns boosted demand for safe-haven assets.

European banking stocks fell sharply, with Deutsche Bank and UBS knocked by worries that actions by regulators and central banks have not yet contained the worst problems to face the sector since the 2008 global financial crisis.

ECB head Christine Lagarde told EU leaders euro zone banks were resilient because they have strong capital and liquidity positions, but that the ECB could provide liquidity if needed, EU officials said on Friday.

U.S. Treasury Secretary Janet Yellen on Thursday reassured that measures would be taken to keep Americans’ deposits safe.

Germany’s 10-year government bond yield, the bloc’s benchmark, dropped 13 basis points to 2.03%.

It fell to its lowest since mid-December 2022 at 1.923% last week on fears of a banking crisis in Europe, after posting its highest since July 2011 at 2.77% in early March.

German 2-year yield, most sensitive to expectations for policy rates, was down 20 bps to 2.28%.

“The ECB will be in a challenging position if wobbles in the banking sector lead to tightening lending standards, as we expect,” said Annalisa Piazza fixed-income analyst at MFS.

“The central bank will not be able to raise rates as previously forecasted,” she added.

Having raised interest rates at the fastest pace on record to tame inflation, the world’s top central banks are openly contemplating an early end to their rate hikes, not least because of financial turmoil in recent weeks.

The August 2023 ECB euro short-term rate forward fell as low as 3.15%, implying expectations for a deposit facility rate to peak at 3.25%. The ECB recently raised its depo rate to 3.0%.

However, Bundesbank President Joachim Nagel on Friday played down the sell-off in bank shares as a natural extension of the recent market volatility, adding that the ECB must continue to raise interest rates to fight inflation.

Business activity across the euro zone unexpectedly accelerated this month as consumers splashed out on services, but weakening demand for manufactured goods deepened the downturn in the factory sector, surveys showed.

Market stress indicators were back within striking distance of levels seen at the height of fears of a banking crisis. The gap between two-year euro swap rates and two-year German bond yields rose to 86 bps, after hitting 89.8 bps. It reached its widest since early November at 96.7 bps on Monday.

Investors’ focus will turn next week to the euro zone’s preliminary inflation for March, as solid data may embolden ECB hawks, rekindling market expectations for rate hikes.

Citi expects the breakdown details of next week’s numbers to be hawkish, with core inflation still up (5.7%).

“It is too early to draw conclusions on the impact of the recent banking turmoil on the inflation outlook, as this will depend on the still-uncertain implications for final demand and the ECB’s reaction,” said Citi economist Giada Giani.

ING expects the relevant core inflation to edge higher to a new record.

Italy’s 10-year bond yield fell 9 bps to 3.96%, with the closely watched spread between Italian and German 10-year yields at 190 bps.

Reporting by Stefano Rebaudo, editing by Christina Fincher