European bond yields roll off multi-year highs

Figures on Tuesday showed consumer inflation expectations dropped in January, even though expectations increased for wage growth, which had supported bonds until Powell's remarks. Money markets show ECB rate expectations remain elevated and the November 2023 ECB euro short-term rate forward is at 4.02% Splits on the ECB's rate-setting body are becoming more public too.

Short-dated European bond yields on Wednesday edged off the multi-year highs they hit earlier in sympathy with their U.S. equivalents after remarks by Federal Reserve chair Jerome Powell spurred traders to price in more rate hikes. Germany's two-year yield reached 3.367% in early trade, its highest since 2008, before dropping back and was last down a whisker at 3.31%.

Italy's two-year yield eased 2 basis points (bps) to 3.85%, just shy of Tuesday's 10-year peak of 3.91%, while the U.S. two-year yield reached 5.084% in Asian trading hours, its highest since 2007. The selloff in bonds, whose prices move inversely to yields, came after Powell told the Senate Banking Committee the Fed will likely need to raise interest rates more than expected given recent strong data and that it is prepared to move in larger steps if required.

He will speak to Congress again later in the day. Shorter-dated bonds are particularly sensitive to interest rate expectations, and futures indicate a 70% chance of a 50 basis point increase at the Fed's next meeting, up from around 30% before the testimony, according to the CME's Fedwatch tool.

"It's clear that the ECB sees what's happening in the U.S. as a leading indicator of what might happen down the road in Europe, and we are now in the extreme of data dependency," said Samy Chaar, chief economist at Lombard Odier. "If employment comes in cool, and a disinflationary narrative is back more convincingly, the Fed will do 25 bps and the ECB will be more relaxed and may push back on market pricing of a peak rate above 4%."

"If, on the contrary, labour market tightness is still visible in the U.S. and inflation remains sticky, the Fed goes 50, and the ECB promotes this idea of 4% plus for the terminal rate." The U.S. reports jobs data this week, most significantly non-farm payrolls on Friday, and inflation next week.

Also in the mix on the domestic front was data on Wednesday that showed the euro zone failed to register any growth quarter-on-quarter in the final three months of 2022, a slight downward revision of GDP and employment growth numbers from earlier preliminary estimates. Figures on Tuesday showed consumer inflation expectations dropped in January, even though expectations increased for wage growth, which had supported bonds until Powell's remarks.

Money markets show ECB rate expectations remain elevated and the November 2023 ECB euro short-term rate forward is at 4.02% Splits on the ECB's rate-setting body are becoming more public too. Governing council member Ignazio Visco on Wednesday criticized some fellow policymakers for comments on future interest rates that diverged from what had been agreed at policy meetings.

Longer-dated bonds were performing a better than short-dated paper. Germany's 10-year yield, the benchmark for the euro zone, was last at 2.66% down 3 bps on the day. Italy's 10-year yield was flat around 4.49%, having dipped 5 bps on Tuesday.