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The ECB's Rate Bets Have Risen To 4%, Sliding Euro-Area Bonds

February 28, 2023
minute read

The bonds within the Eurozone tumbled and traders bet that the European Central Bank will raise interest rates to the highest level on record as there are signs that inflation in some of the region's biggest economies is not in check.

A selloff was triggered Tuesday after figures showed that French and Spanish inflation unexpectedly accelerated in February, pushing the two- and 10-year German yields up to levels not seen since more than a decade ago.

There was a brief period when Trade Algo traders priced a 4% ECB terminal rate in reaction to the release, which would have exceeded the peak in borrowing costs at the beginning of the century. Compared to earlier this year, the ECB was expected to raise rates by 3.5%, but traders now expect that the ECB will keep raising rates until February 2024. 

A series of outsized hikes in interest rates over the past few months have resulted in a rise in borrowing costs of 300 basis points since July, yet the European economy remains more resilient than expected. There will now be a focus on the euro-area inflation data due on Thursday, which is likely to fuel bets that even more aggressive action will need to be taken if any indications that price pressures are broad-based and entrenched are found.  

Piet Christiansen, a chief strategist at Danske Bank A/S, stated that markets have not yet fully priced in the peak. "It may push higher, particularly the May meeting pricing, which is still pricing a coin toss probability between 25 basis points and 50 basis points."

Traders Bet on ECB's Key Rate Hitting 4%

Money-market traders increase their wagers in response to hotter inflation data.

There is quite a turnaround from recent exuberance. Just three weeks ago, it was widely expected that the central bank would stop raising interest rates by the middle of the year. 

Tuesday, the yield on two-year German bonds reached 3.20%, the highest since 2008 and nearly 80 basis points above the low reached in mid-January. It is the highest level since 2011 that the 10-year yield climbed as much as 13 basis points to 2.71%, the highest level since 2011.

Throughout the last few months, policymakers have been warning that the market has become too complacent about the outlook and has underestimated the bank's commitment to delivering inflation back to its target of 2%. As part of comments published Tuesday in the official press release of the European Central Bank, ECB Chief Economist Philip Lane said that the central bank might hold borrowing costs at their peak for some time to come.

Tim Graf, the head of the macro strategy for EMEA at State Street Global Markets, said, "The question now is whether more hikes or hikes that are more aggressive, are necessary." He explained, "The terminal rate re-pricing in recent weeks may need to be adjusted even further."

The consumer price index in France has increased by a record 7.2% from a year ago, according to data released on Tuesday. It was a 6.1% increase in headline inflation in Spain, while an underlying inflation measure that excludes energy and fresh food reached a new all-time high of 7.7%. There is also evidence that traders have revised their expectations of long-term inflation, with one measure of market bets on price growth approaching its highest level in more than a decade.

It has been reported that the repricing has spread beyond euro-area markets, with 10-year Treasury yields approaching 4% for the first time since November. Traders have jolted out of the belief that the economy would cool down rapidly as a result of the rise in interest rates as a series of stronger-than-expected US economic data has helped jolt traders out of belief.

As of 3:27 p.m. in London, the euro traded 0.3% higher at $1.0641 after earlier dropping against the dollar.

“There is a perception among investors that inflation is very sticky,” according to Francesco Maria di Bella, a strategist with UniCredit Bank AG. "As a result, the ECB would remain very hawkish."

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