By Stefano Rebaudo
(Reuters) - Euro zone borrowing costs fell sharply on Tuesday as investors covered short positions after recently pushing yields to multi-year highs on aggressive European Central Bank tightening bets.
Meanwhile, the spread between Italian and German 10-year rates narrowed below 200 bps.
"The medium-term trend doesn't change, but with the U.S. yield at 3%, Bund at 1.1% and (Italian) BTPs at 3%, it makes sense to cover short positions, which is what is happening right now," said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors.
Some analysts reckon markets might have gone too far in pricing in ECB monetary tightening but bonds remain vulnerable to further selloffs as the central bank recently sounded more hawkish, doing little to soothe investors' angst.
The European Central Bank should raise interest rates in July to stop high inflation from getting entrenched, Bundesbank chief Joachim Nagel said on Tuesday, joining an already long line of policymakers calling for quick rate moves.
The 10-year Bund yield, the bloc's benchmark, fell 8.5 basis points (bps) to 1.007%. On Monday, it hit its highest since August 2014 at 1.189%.
U.S. Treasuries also applied further downward pressure on euro zone borrowing costs, with the U.S. 10-year yield falling 6 bps to 2.97%.
"We think the (euro zone) government bond market (selloff)will pause in the next few days as it has to digest a sharp selloff in risky assets involving equities and credit," said Philippe Gräub, head of global fixed income at UBP.
Risk-aversion usually boosts demand for safe-haven government bonds, driving yields down.
Money markets are currently pricing 86 bps of ECB rate hikes by year-end, from around 95 bps on Monday.
The spread between Italian and German 10-year bond yields tightened 9 bps to 197.1 after hitting its widest since May, 2020 on Monday at 206.90 bps.
It was at 209 bps on May 18, 2020, right after the news that France and Germany proposed a 500 billion euro ($528.20 billion) Recovery Fund that would offer grants to European Union regions and sectors hit hardest by the pandemic.
"It was the perfect storm for the Italian German yield spread, with central bankers worried about inflation, while risky assets fell on concerns about economic growth," said Rohan Khanna, research strategist at UBS.
The yield spread between core and periphery has recently widened as hopes for further monetary and fiscal support for indebted southern European countries have faded.
Italy's 10-year government bond yield fell on Tuesday by 15.5 bps to 2.99% after hitting its highest since December 2018 at 3.232% on Monday.
German investor sentiment rose slightly in May on expectations the economic situation in Europe's largest economy will deteriorate less markedly than predicted previously as the European Central Bank acts to tame inflation.
($1 = 0.9466 euros)
(Reporting by Stefano Rebaudo, Editing by Kirsten Donovan)