Eurozone bond yields edged up on Thursday as investors saw better-than-expected economic data as quelling the need for the European Central Bank to loosen monetary policy further.
Germany - the bloc's economic engine room - was set to record the fastest growth rate for three years in its services sector, preliminary data showed, seen fuelling an impressive expansion in the euro area's private sector.
The data pointed to an upturn in the health of the eurozone economy, which has been propped up in recent months by ultra-easy ECB policy that has in turn pinned government borrowing costs at record lows.
Strategists said that without signs of recovery, markets had expected the ECB to embark on quantitative easing via a programme of asset purchases - a prospect that has now diminished.
"The data came against the trend,» said Piet Lammens, a strategist at KBC.
"The market had discounted too much a situation where there is no quantitative easing, so you would expect yields to go higher."
German 10-year yields edged 2 bps higher on Thursday to 1.17 percent, while all other euro zone bond yields edged higher by between 0.2 and 2.2 bps.
Italian 10-year bonds reversed earlier gains but were still some of the best performing assets relative to their peers, with yields up just 0.2 bps at 2.74 percent.
Traders said Italy's decision to cancel scheduled bond auctions in mid-August had created more demand for peripheral bonds in the secondary market.
Eurozone money market rates edged higher on Thursday and were expected to rise further in coming days, potentially driving up short-term government bond yields, after a drop in excess cash in the bloc's banking system.
The euro overnight interbank lending rate moved back up to the top end of its recent trading range on Wednesday, analysts said, while forward rates imply it will almost double by the European Central Bank meeting in September.
"The market is pricing in this scenario we have been expecting all along - one with downside risks to liquidity and upside risks to rates for most of this summer,» said Christoph Rieger, a strategist at Commerzbank.
The spare cash in the eurozone banking system dropped to 104 billion euros on Thursday, its lowest in over a month, after a bumper 21 billion euros of long-term loan repayments by banks on Wednesday.
"This will have an upwards pressure on Eonia. From currently around about 5 (basis points), I could see it move up to 8, maybe 9,» said RBC's head of European rates strategy Peter Schaffrik.
A push higher in money market rates should also see short-dated bond yields rise more than those on longer-term bonds, strategists said.
Commerzbank's Rieger said German bond futures already show this trend with two-year Schatz futures close to their lowest in a month and 10-year Bund futures at one-month highs .
Strategists predict this trend will continue during the northern summer months, but that the liquidity squeeze is likely to ease in September when the European Central Bank offers its first round of targeted long-term loans to banks. [Reuters]