LONDON: German 10-year bond yields topped 0.1 percent on Monday for the first time since the results of the Brexit referendum in June, pushed higher by rising US and British yields as investors turned their focus to this week's European Central Bank meeting.
The ECB may discuss technical changes at this week's meeting that would allow it to extend its 1.7 trillion-euro ($1.90 trillion) of asset purchases beyond the March 2017 end-date, at a time when talk of a potential "taper" of its scheme has put markets on edge.
Bond yields have risen since the ECB last met in September, with more offering a yield above the bank's eligibility threshold. That creates some space for the ECB, which faces a scarcity of eligible bonds for quantitative easing.
Germany's 10-year bond yield, for instance, is up 21 basis points this month, moving out of negative territory to top 0.1 percent on Monday, its highest since the results of Britain's referendum on European Union membership on June 24.
A suggestion by Federal Reserve Chair Janet Yellen on Friday that the central bank may allow inflation to exceed its 2 percent target pushed US bond yields to four-month highs.
Meanwhile, fears about the implications of Brexit sparked further selling in British gilts that spilled over into the euro zone, where yields rose 3-6 bps .
TAPER?
Commerzbank estimates that the ECB will run out of eligible German sovereign and agency paper to buy by next summer, pushing back that deadline from last month, when yields were lower.
Analysts expect the ECB to keep policy unchanged this week and wait until December to announce a possible extension and tweaks to the programme.
Still, the ECB's news conference with President Mario Draghi will be scrutinized as investors assess both the scope for further easing and eventual tapering.
"Rhetoric will be very important this week," said Martin Van Vliet, senior rates strategist at ING. "Draghi will try to play down the taper talk and may give some hints on what to expect in December."
Most economists do not expect the ECB to start scaling back its massive monetary stimulus soon, but note that a report this month that the ECB might reduce or 'taper' the scale of its purchases before the scheme finally ends has struck a chord.
Market pricing suggests a 10 bps rate cut is priced in by the end of 2017.
INFLATION KEY
Against this backdrop economic data could play a more important role in shaping market expectations for what the ECB will do next.
"We think the ECB will declare victory once it becomes more and more certain that inflation is moving above 1 percent and then it will start to prepare markets for tapering," said Shweta Singh, a senior economist at Lombard Street Research.
Data on Monday confirmed euro zone inflation in September at 0.4 percent, well below the ECB's target of just under 2 percent.
It is expected to rise in coming months on higher oil prices. A key market gauge of long-term inflation expectations has started to move higher. The five-year, five-year breakeven forward, which measures where the market expects 2026 inflation forecasts to be in 2021, is trading around 1.42 percent -- its highest level since June.
Still, euro zone bond markets are not expected to witness a "taper tantrum" on the same scale as US bond markets went through in 2013 when former Federal Reserve Chairmen Ben Bernanke first suggested that quantitative easing in the US would be slowly wound down.
The experience of that sell-off, which saw US Treasury yields jump just over 100 bps between May 2013 and early 2014, could weigh on the ECB's mind.
UBS estimates that long-dated yields on core euro zone government bonds will rise by around 70 bps by the time QE is fully tapered.
"With tapering likely to start next year, you will continue to see bond buying throughout 2017," said Mark Dowding, co-head of investment grade, BlueBay Asset Management.
"In this environment, German Bunds are going to remain scarce and that will limit how high yields can rise in a material fashion."
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