By Yoruk Bahceli
(Reuters) - German two-year bond yields were set for their biggest daily fall since 2005 on Friday as data showing business activity in the bloc unexpectedly contracted this month pushed traders to reprice their interest rate expectations.
Overall activity in the euro zone shrank due to an accelerating downturn in manufacturing and a near-stalling of service sector growth, with inflation pushing consumers to cut back spending, S&P Global's Composite Purchasing Managers' Index, a good gauge of economic health, showed.
Germany's two-year yield, sensitive to interest rate expectations, dropped as low as 0.355% and was down over 26 bps to 0.399% by 1530 GMT, set for its biggest daily fall since January 2005 as markets reduced their bets on European Central Bank rate hikes this year.
Traders now price in 105 bps of ECB rate hikes by December, down from around 120 bps before the data, according to Refinitiv data. They price in an 80% chance of a 50 basis-point rate hike in September, down from a full probability on Thursday.
"I think it's pretty clear that the market is growing increasingly worried about a eurozone recession this winter - activity is already falling off a cliff, and that's before any potential Russian gas cut-off into the winter. The big bid into bonds is no surprise", Michael Brown, head of market intelligence at Caxton, said.
Germany's 10-year bond yield, the benchmark for the euro area, fell below 1% for the first time since May 30, and was last down 19 bps. Bond yields move inversely to prices.
"The window for meaningful rate hikes is rapidly closing. We really don’t think they’ll be in a position to tighten at the turn of the year or (the first half of 2023) given that where the European economy is likely to be," Viraj Patel, global macro strategist at Vanda Research. said.
The ECB hiked rates by 50 bps - double what it previously guided - and exited negative territory on Thursday.
Elsewhere, Italian bond yields fell, tightening the closely watched 10-year spread to Germany to 238 bps, from 240 bps at end-Thursday.
In focus remained the ECB's long-awaited new tool, the Transmission Protection Instrument (TPI), announced on Thursday, to buy bonds from countries whose spread to Germany the bank sees as soaring through no fault of their own.
Policymakers did not discuss bond market turmoil in Italy, whose government collapsed this week, at Thursday's meeting and do not expect to use their new tool imminently as conditions do not warrant it, sources told Reuters overnight.
The spread briefly widened to as high as 247 bps on Friday, nearing the peak on Thursday when investors were disappointed with the tool's degree of conditionality and the lack of detail provided.
(Reporting by Yoruk Bahceli; Editing by Susan Fenton, Louise Heavens and Andrew Heavens)