Euro zone yields rise as hopes for quick end of tightening cycle fade

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Euro zone government bond yields rose and spreads between core and periphery yields widened on Monday as investors’ hopes for a quick end to the monetary policy tightening cycle were fading.

Borrowing costs plunged last Thursday as remarks from the European Central Bank (ECB), the Federal Reserve and the Bank of England (BoE) fueled speculation that the rate hiking path would be shorter than previously expected.

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The day after, robust U.S. economic data and hawkish comments from ECB policymakers triggered a sharp bond sell-off, driving euro area borrowing costs back up.

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Germany’s 10-year government bond yield, the bloc’s benchmark, rose 8.5 basis points (bps) to 2.28%. It hit a 2-week low at 2.04% last Thursday after the ECB policy meeting, where it hiked its deposit rate by 50 bps to 2.5%, while the yield was at 2.27% before the meeting.

The ECB euro short-term rate (ESTR) August 2023 forward was around 3.4%, implying an ECB deposit rate of 3.5% by this summer. The August 2023 forward fell to about 3.25% last Thursday.

“What changed in the last few days was that data from the U.S. were much stronger than expected,” said Joost van Leenders, senior investment strategist at Van Lanschot Kempen.

“The Fed and the ECB said last week they would hike more, but markets didn’t believe them,” he added. “I guess now they have to believe them as the U.S. economy appeared to be more resilient, and the ECB still has to tame sticky inflation.”

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Sentix’s index for the euro zone showed that investor morale in the bloc improved for the fourth month in a row in February to reach its highest since March 2022.

A 5-year market gauge of inflation expectations rose to its highest since Jan. 4 at around 2.35%.

Investors will focus on comments from ECB’s Isabel Schnabel and Fed Chair Jerome Powell, due on Tuesday.

Analysts reckoned Powell could answer the question of whether a strong U.S. labor market might derail expectations that the Fed’s tightening cycle is nearing its end.

ECB’s Schnabel might clarify how much ECB monetary policy could diverge from the Fed’s.

“Near-term, the focus should be back on the final leg higher in central bank rates with the market response sensitive to data surprises,” said Rainer Guntermann, strategist at Commerzbank.

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“This should also keep Bunds and curves on a choppy trajectory,” he added. “The hawkish ECB bias and moderating inflation should limit the re-steepening potential, though.” Bond prices move inversely with yields.

Austrian central bank chief Robert Holzmann said on Monday the risk of the ECB not raising interest rates high enough was still bigger than that of lifting them too much.

ECB Governing Council member Ignazio Visco advocated a cautious approach to monetary tightening, adding that “risk of Italian bond spread increasing will be contained as long as budgetary policies remain cautious.”

Some analysts reckoned the post-ECB bond rally was overdone, likely compounded by the dovish read on the Fed and BoE.

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Fed’s Powell referred to a “disinflationary” process taking hold, while Governor Andrew Bailey said the BoE had “seen the first signs that inflation has turned the corner.”

However, ECB President Christine Lagarde explicitly signaled at least one more 50 bp hike next month and reaffirmed the central bank would “stay the course” in the fight against high inflation.

Italy’s 10-year bond yield, the benchmark for so-called periphery euro zone countries, rose 12.5 bps to 4.16%, with the closely watched spread between Italian and German 10-year yields widening to 187 bps.

(Reporting by Stefano Rebaudo Editing by Kylie MacLellan and Mark Potter)