European bonds hit with renewed selling after ‘hawkish ECB pivot’

European government bonds were hit with a fresh wave of selling on Friday as traders ratcheted up their expectations that the European Central Bank will assume a far more aggressive tack in pushing back against record inflation.

Short-term debt, which is particularly sensitive to monetary policy, came under strong pressure in morning dealings on Friday. Germany’s five-year government bond yield jumped 9 basis points (0.09 percentage points) to 0.03 per cent, leaving it on track to close above zero for the first time since 2018, according to Bloomberg data.

Investors are now pricing in expectations that the ECB will raise its deposit rate from minus 0.5 per cent at present to almost zero by the end of the year, according to money markets trading. A week ago, markets had signaled an increase to minus 0.38 per cent, Bloomberg data show.

Line chart of Five-year Bund yield (%) showing Short-term German bond yields rise on expectations for ECB tightening

The marked shift in investor sentiment came after Christine Lagarde declined on Thursday to rule out rate rises this year to rein in inflation that is running at a historic high of 5.1 per cent. Only last month, the ECB president had dismissed such a move as “very unlikely”.

“President Lagarde signaled a hawkish policy pivot at yesterday’s meeting and we now look for a substantially earlier policy exit,” said Sven Jari Stehn, chief European economist at Goldman Sachs.

Goldman now expects the ECB to end its massive asset purchase program in June, followed by 25bp rises in September and December, leaving the central bank’s main policy rate at zero by the end of this year.

Just as ECB policymakers seemed to have been stunned by the persistence of inflation, their decision to signal a more aggressive tightening of policy unsettled veteran eurozone economists. “What a mess,” said Erik Nielsen, chief economics adviser at UniCredit, adding that Lagarde was “clearly shaken by the latest inflation number and wanted to buy insurance – but [caused] chaos in the process “.

Lagarde said the ECB would not decide any changes in policy until it published new forecasts in March, which are widely expected to show inflation hitting its target over the next two years – a key condition for it to raise rates. She said there was consensus among ECB policymakers that it should first stop net asset purchases before raising rates.

Giovanni Zanni, chief euro area economist at NatWest, added that Lagarde now appeared to be “morphing into a hawk” as she takes more seriously the risks that inflation continues to seriously overshoot the ECB’s target of close to, but less than, 2 per cent .

“Inflation has been stickier than originally anticipated and risks are now tilted to the upside,” added Fabio Bassi, a rates strategist at JPMorgan.

The ECB’s big pivot has also knocked out the debt of other eurozone countries. Italy’s five-year bond yield rose 5bp on Friday to 0.85 per cent. It had traded at 0.47 per cent a week ago. Similar rises in borrowing costs also took place in other big eurozone economies such as Spain.

Line chart of Spread in 10-year bond yields (bps) showing Gap in Italian and German borrowing costs at widest point since 2020

The gap between Italy’s 10-year government bond and the equivalent German Bund hit 150bp on Thursday for the first time since September 2020, in a sign markets are growing more anxious that a sharp tightening in ECB policy could hurt the bloc’s most indebted members.

Krishna Guha, vice-chair of Evercore ISI, said the ECB had “more cause than its peers to ensure” any phasing out of net asset purchases was done gradually “because it has to worry about spreads in the European periphery”.

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