Euro zone short-dated bond yields tick up after ECB hike

Euro zone short-dated yields rose slightly on Thursday after the European Central Bank's rate decision as Wednesday's Federal Reserve policy meeting led markets to price in more ECB tightening earlier in the session. The ECB raised borrowing costs to their highest in 22 years and left the door open to more hikes, extending its fight against inflation that remains stubbornly high even as the euro zone economy flags.

Euro zone short-dated yields rose slightly on Thursday after the European Central Bank's rate decision as Wednesday's Federal Reserve policy meeting led markets to price in more ECB tightening earlier in the session.

The ECB raised borrowing costs to their highest in 22 years and left the door open to more hikes, extending its fight against inflation that remains stubbornly high even as the euro zone economy flags. Germany's two-year yield, particularly sensitive to changes in policy rate expectations, by 1521 GMT was up 13 basis points (bps) at 3.17%, after reaching a new three-month high at 3.195%. It was around 3.15% before the ECB decision.

"The slight upward review of ECB inflation forecasts supported expectations for more tightening," said Massimiliano Maxia, senior rate strategist at Allianz General Investment. "Now, another 25 bps is more than certain in July, we will see what happens in September."

Analysts were not expecting a sharp reaction as the market has been pricing two 25 basis point (bp) rate hikes for a while. Earlier in the session, money markets priced in the chance of another ECB move, which would lift the deposit facility rate to 4%, after the Fed delivered what some analysts called "a hawkish skip".

The Fed on Wednesday left interest rates on hold, but its projections showed borrowing costs could still rise by as much as half a percentage point by the end of the year. "Our U.S. economists recently pushed out the timing of their recession call, pencilled in more Fed hikes and slightly pushed out timing of rate cuts," BofA said in a research note.

November 2023 ECB euro short-term rate (ESTR) forwards were at 3.8%, implying expectations for a deposit facility rate at 3.9% by year-end. They were at 3.77% before the ECB statement. "We believe risks to the (ECB) terminal deposit rate of 3.75% are skewed to the upside, given significant uncertainty about the inflation process," Anna Stupnytska, global macro economist at Fidelity, said by email.

Germany's 10-year bond yield, the benchmark for the euro area, was up 6 bps at 2.50%. "All of this (Thursday's ECB remarks) suggests the ECB is headed to taking rates closer to 4%," said Katharine Neiss, chief European economist at PGIM fixed income, after mentioning the ECB upgrade of inflation forecasts.

"For now, it looks like the key variable for the ECB is real time inflation data." ECB officials' recent comments pointed to a broad consensus that more monetary tightening would be required, with most of the Governing Council supporting two final 25 bp hikes in June and July. However, a few, including hawkish governing council members Klaas Knot and Joachim Nagel, mentioned the possibility of raising rates after July.

Italy's 10-year yield, the benchmark for the euro area periphery, was up 5 bps at 4.15%. The spread between Italian and German yields was at 163 bps, after reaching a fresh 14-month low below 160 bps.