German 2-year bond yield rises to fresh 14-year high after ECB

A slowdown in U.S. and euro zone inflation has recently raised hopes that central banks will stop or pause hiking interest rates in early 2023. Analysts expect the spread between U.S. and German 10-year yields to fall as the Fed is closer than the ECB to the end of its monetary tightening cycle.

Euro zone bond yields jumped on Thursday after the European Central Bank (ECB) delivered a widely expected 50 basis point rate hike but pledged further tightening to fight inflation.

The ECB signalled that borrowing costs would remain at restrictive

levels - economic parlance for financing conditions that curb growth - for a long time. "The ECB statement made clear that there is still a long way to go in terms of monetary tightening," said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors.

"The upward revision of 2023 inflation forecasts to 6.3% and the statement about a recession which will be 'short-lived and shallow' triggered the bond selloff," he added. The ECB sees average inflation reaching 8.4% in 2022 before decreasing to 6.3% in 2023.

The yield on Germany's 10-year government bond rose 15 bps after hitting 2.12%, its highest level since November 16. Yields move inversely to prices. The two-year yield, which is most sensitive to interest rate expectations, was up 24.5 bps -- in its biggest daily rise from the global financial crisis -- at 2.37%, its highest level since December 2008.

Germany's announcement that it would issue a record amount of debt in 2023 to fund an energy support package also put upward pressure on yields, analysts said. Italy's 10-year yield was up 27 bps at 4.12%, its highest since November 14. That pushed the gap between Germany and Italy's 10-year yields to 204 bps.

Forwards now price in ECB policy rates to peak at around 3.05% next summer, up from 2.8% before the ECB statement. The ECB said it would start reducing its large holdings of government debt, in a move often called

quantitative tightening (QT), from March 2023.

The consensus was already eyeing a beginning of QT at the end of Q1 or early Q2 2023, analysts said. The Fed on Wednesday raised its main interest rate by 50 bps to a range of 4.25% to 4.5%, marking a slowdown after four consecutive 75 bp increases.

Yet Fed officials predicted that they expected to raise rates to around 5.1% in 2023, higher than the 4.6% peak envisaged in September. A slowdown in U.S. and euro zone inflation has recently raised hopes that central banks will stop or pause hiking interest rates in early 2023.

Analysts expect the spread between U.S. and German 10-year yields to fall as the Fed is closer than the ECB to the end of its monetary tightening cycle. The U.S.-German yield spread dropped 15 bps on Thursday to 139 bps.

The Bank of England also raised its key interest rate, by an expected 50 bps to 3.5%, on Thursday.