Europe’s bond recovery falls at first hurdle after ECB high

ALL it took was a strong US jobs report to expose the fragility of last week’s bond rally in Europe. 

Within minutes of the release last Friday (Feb 3), German bonds had erased almost half of their day-before rally, which had been turbocharged by expectations that central banks were nearing an end to their hiking cycles.

Jubilation is giving way to fresh anxiety among bond traders that the world’s largest economy needs a bigger dose of monetary tightening, and the surge in US payrolls served as a reminder that central banks are far from done applying the brakes. Bets on the scope of future hikes in Europe increased slightly after the data, but the risk is the market is still taking a far-too sanguine view.

“While we may not see many more rate hikes, it doesn’t mean we’re out of the woods yet,” said Azad Zangana, senior European economist and strategist at Schroders. “Investors need to understand that there is two-way risk for the rest of the year.”

Eurozone policymakers raised rates by half a point to 2.5 per cent last Thursday, the highest since 2008, and signalled that another 50 basis-point (bp) hike is coming in March. Though headline inflation slowed more than expected, a separate core metric that strips out energy and food held at an all-time high last month, and it is still unclear what impact the reopening of China’s economy will have on the pace of price growth in Europe. 

But traders shrugged that off, along with European Central Bank (ECB) president Christine Lagarde’s warnings on underlying inflationary pressures, instead latching onto her verdict that the risks are now “more balanced”.

“Everything is in place for higher rates – you have supported growth, sticky core inflation in Europe, as well as China,” said Ute Rosen, a senior derivatives specialist at Union Investment. 

After a dire year in 2022 for fixed income, investors are more inclined to jump on any sign of a pause in hikes. While yields have fallen back from cycle highs, they remain close to their most elevated levels in years.

Thursday’s rally was “a case of short covering” and “speaks to a certain amount of fear-of-missing-out”, said Marc Ostwald, chief economist and global strategist at ADM Investor Services. “Markets are for the most part wilfully blind, with a strong penchant for ‘wishful seeing.’”

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Eurozone bond yields up as ECB maintains monetary tightening path

The 10-year German yield rose to 2.20 per cent last Friday, erasing more than half of the previous day’s 20 bp drop. Wagers on the ECB’s peak rate rose 5 bps to 3.45 per cent, though that was still below the more than 3.5 per cent priced prior to Thursday’s meeting. 

To be sure, after five back-to-back rates hikes, there is growing conviction Europe’s bond market is on the cusp of a lasting recovery after several false dawns last year. 

HSBC Holdings’ rates strategist Chris Attfield sees little reason to expect higher yields at this point. “Markets are increasingly looking past the central banks’ near-term hawkishness to the prospects for 2024 and beyond,” he said. “The ECB may ‘stay the course’ to a peak rate above 3 per cent, but in the face of more balanced risks to inflation, there was room to price in the greater chance of a cutting cycle in 2024.”

Still, the ECB’s job is harder because it embarked on its tightening path months after the Federal Reserve and Bank of England (BOE) did so. Fed chair Jerome Powell emboldened doves last week when he said the disinflation process had started – and did not push back against the rate cuts priced – while BOE governor Andrew Bailey said inflation had turned a corner. 

Real rates retreated following Thursday’s meeting, a likely source of frustration for the ECB, said ING Bank strategist Antoine Bouvet. The five-year euro short-term rate, once adjusted for inflation, more than halved to around 18 bps.

Officials were quick to push back against the dovish sentiment. Governing Council member Gediminas Simkus said on Friday that next month’s planned half-point increase in interest rates may not be the last, while fellow board member Peter Kazimir said the fight against inflation is “far from won”. 

The ECB’s survey of professional forecasters published at the end of the week showed that expectations for both headline and core inflation in 2025 were above the 2 per cent target.

“I’m surprised the central banks weren’t more forceful in saying that the market needs to wait for rates to come down,” said Howard Cunningham, fixed-income portfolio manager at Newton Investment. “While we think the real inflation shock is abating, we’re not convinced that the war on inflation is won. The battle maybe, but not the war.” BLOOMBERG