Bond market starting to believe ECB higher-for-longer pledge

THE European Central Bank’s (ECB) message that interest rates will stay higher for longer is finally sinking in with the bond market.

Traders are selling German 10-year government securities – the benchmark for long-term borrowing cost in Europe – at the fastest pace since February this month, driving the yield to its highest since 2011.

The move highlights the bind ECB policymakers face in trying to return inflation to 2 per cent without triggering a recession. Data on Monday (Sep 25) signalled only a slight improvement in the gloomy outlook for businesses in Germany, the continent’s top economy.

Bank of France governor Francois Villeroy de Galhau summed up the dangers, cautioning against steps that could derail the meagre growth that remains in the eurozone, while insisting officials focus on the “persistence” of monetary policy following a 10th straight hike in the deposit rate to 4 per cent this month.

The 10-year German bond yield climbed above 2.8 per cent – more than 30 basis points higher this month. The euro, meanwhile, has been in locked in a downward spiral for more than two months, weighed down by mounting fears over stagflation. It was trading around US$1.0635, around its lowest levels since May.

Isabelle Vic-Philippe, a fund manager at Amundi, said she is avoiding adding excess interest-rate risk to her portfolio given that central bankers may maintain tighter conditions for longer than markets currently expect.

“You have inflation still quite high, even if it’s decelerating,” she said. “This deceleration is something that’s occurred already in the US and, in the meantime, rates have increased.” 

The repricing in Europe is driven in part by data out of America last week showing the economy remains far stronger than many expected after the Federal Reserve’s own aggressive hiking campaign.

US Treasury yields have surged in recent weeks, despite inflation making further headway back towards the Fed’s 2 per cent target. The 10-year breached the 4.5 per cent level last Friday, a 16-year high.

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The ECB is still some distance from hitting its inflation goal, though figures due this week are likely to show a steep decline in both headline and underlying measures of consumer-price gains.

The retreat could yet be aided by the weak economic backdrop: second-quarter expansion in the 20-nation euro area was revised sharply down recently and Germany is seen contracting in the third, having endured a recession during the winter. 

There is little prospect of imminent relief from looser monetary policy, however, with ECB president Christine Lagarde insisting the Governing Council has not “decided, discussed or even pronounced cuts”.

For markets, such talk has contributed to a step change. Long-dated bonds preformed better than short-dated peers in the early stages of the tightening cycle. But if the ECB looks serious about keeping policy restrictive for longer, the incentive to hold debt that matures further in the future will quickly diminish.

Strategists are starting to mull the possibility of Germany’s 10-year bond yield advancing to 3 per cent.

“Looking at how long-end bonds are trading globally, it’s increasingly evident that a more dramatic deterioration in macro data may be needed to generate a sustained turnaround in yields,” said Rohan Khanna, rates strategist at Barclays. BLOOMBERG