LONDON: Borrowing costs in the euro area’s battered sovereign bond markets crept back up on Thursday, before an European Central Bank meeting likely to witness another intense debate over how to tackle record high inflation. The ECB may outline a clearer schedule for unwinding its extraordinary stimulus, as price pressures trump concerns about a possible war-related recession.
Bond yields have marched higher as investors bet the ECB will hike rates sooner rather than later to curb inflation which, at 7.5%, is well above its 2% target. The German 10-year bond yield, up 2.5 basis points (bps) at 0.80%, is near the highest levels since July 2015 that it hit early this week. It is has surged almost 100 bps this year.
French and Dutch yields were also near recent multi-year highs, and a key market gauge of long-term euro zone inflation expectations was close to the decade high it hit on Wednesday. ECB policy hawks may press for a precise end date for asset purchases, currently expected to finish sometime in the third quarter.
Societe Generale senior European economist Anatoli Annenkov said that, with survey data suggesting the euro area economy is holding up well and with inflation high, the ECB could soon stop asset purchases.
“I don’t think they will announce anything now but at coming meetings they could say they will stop in June and that opens the door for rate hikes,” he said.
Annenkov expects 25 bps rate hikes in September and December. That would take the ECB’s -0.5% depo rate to 0%. Markets price in almost 70 bps worth of tightening by year-end - the equivalent of almost three, 25 bps rate hikes.
Many central banks have stepped up their inflation fight. Canada and New Zealand this week raised rates by 50 bps, the biggest hikes in two decades for both. South Korea and Singapore tightened policy on Thursday and the US Federal Reserve is expected to hike by 50 bps in May.
In southern Europe, concern that asset purchases could end sooner than anticipated, removing a key pillar of support, has started to sink in. Italy’s 10-year bond yield was up around 5 bps at 2.43% and is up almost 40 bps so far in April. The spread over safer German Bunds is expected to widen from current levels around 160 bps.
Sharp bond spread widening would be a concern for the ECB, tightening financing conditions at a time when the war in Ukraine is already hurting the euro area economy. “I wouldn’t be surprised if they start to raise rates before the year is out, but clearly the situation is highly uncertain,” said Katharine Neiss, chief European Economist for PGIM Fixed Income. “We don’t know what will happen with energy flows from Russia, the plummet in confidence is concerning, and so I expect (ECB President Christine) Lagarde to emphasize flexibility.”
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