Euro zone government bonds steady as inflation expectations hit three month low

LONDON: Euro zone government bond yields were broadly steady on Monday, rising by less than one basis point, while a measure of long-term inflation expectations in Europe hit its lowest in three months, as investors adjust to the Fed's hawkish shift.

The Fed surprised some investors last week by anticipating two rate hikes in 2023, which prompted US Treasury yields to rise and global markets to turn risk-averse. St. Louis Fed President James Bullard fuelled the market sell-off on Friday by saying that it was natural for the Fed to have "tilted a little bit more hawkish here to contain inflationary pressures."

The US yield curve, measured as the spread between the US two-year and 30-year Treasury yields, touched its lowest since late January overnight, although by European trading some of this move had reversed, with US Treasuries broadly flat on the day.

Germany's 10-year Bund yield edged slightly higher, and stood at -0.197% at 1138 GMT.

Spain and Italy's 10-year yields were flat while France's was around 2 bps lower .

But the impact of the Fed's move on the euro zone could be seen in a gauge of long-term inflation expectations - the five-year, five-year inflation forward - which fell to its lowest since March, at 1.4887%.

The gauge had hit its highest since 2018 in May as investors had bet that a combination of central bank stimulus and an economic rebound from the COVID-19 pandemic would cause higher inflation - the so-called "reflation trade".

"It looks like there's been a broader reassessment by investors of the whole reflation trade," said Antoine Bouvet, senior rates strategist at ING.

"(If) we have a Fed that instead is reacting early then it makes sense that long-term inflation expectations drop."

"If the Fed acts early, they kind of open the way for other central banks to act early as well."

ECB President Christine Lagarde is due to speak before the European Parliament at 1415 GMT.

Lagarde said on Sunday that ECB policymakers meeting this weekend had made "good progress" in reshaping the ECB's strategic goals, including the role it plays in fighting climate change and a revised approach to inflation.

Investors this week will also focus on the Bank of England's monetary policy meeting on Thursday and the release of euro area flash PMI data on Friday.

ING's Bouvet said that he expects the German Bund yield to dip in the short term as markets may still seek safer assets due to concern about rising COVID-19 cases.