Bond investors await ECB, markets price a 65% chance of 25 bps rate hike

Germany’s 10-year government bond yield, the benchmark for the euro area, was down 0.5 basis points (bps) at 2.65%. "The ECB may prefer one last hike to boost credibility and keep the market guessing about more to come rather than allow the rally in real yields to gain momentum," said Citi analysts in a research note.

Bond investors were on hold on Thursday ahead of the outcome of the European Central Bank (ECB) policy meeting later in the day, while pricing in an around 65% chance of a 25 basis points rise.

Money markets have raised their bets on the central bank's tightening path steadily since Sept. 6, when U.S. Institute for Supply Management (ISM) service sector data unexpectedly accelerated in August, and some ECB hawks said markets might have been underestimating the chances of a rate hike. Bets on a tightening move briefly rose to 80% on Wednesday, while ECB euro short-term rate (ESTR) forwards fully priced in a deposit facility rate at 4% after Reuters reported that the ECB expects euro zone inflation to remain above 3% in 2024.

Analysts said such a revision of inflation forecasts is unlikely to go along with a pause in the tightening cycle. The ECB depo rate is currently at 3.75%. June's ECB staff projections saw inflation at 3% in 2024 and 2.2% in 2025.

ECB ESTR forwards price no rate hikes after December 2023 and the first cut in summer 2024. Germany's 10-year government bond yield, the benchmark for the euro area, was down 0.5 basis points (bps) at 2.65%.

"The ECB may prefer one last hike to boost credibility and keep the market guessing about more to come rather than allow the rally in real yields to gain momentum," said Citi analysts in a research note. They also mentioned the possibility that the ECB would show "more hawkish intention than simply higher-for-longer."

Several ECB officials recently said rates will have to stay at high levels for an extended period to tame sticky inflation. Italy's 10-year government bond yield, the benchmark for the euro area's periphery, was flat at 4.46%.

Investors will scrutinize any reference to further moves to reduce the ECB's vast bond portfolio in the statement or during the press conference of President Christine Lagarde. Several ECB hawks recently called for ending reinvestments from bonds bought under the 1.7 trillion euro ($1.8 trillion) Pandemic Emergency Purchase Programme (PEPP) earlier than the current end-2024 deadline.

Some analysts expect such a move to weigh on bond prices, mainly affecting the euro area's periphery. The spread between Italian and German 10-year yields - a gauge of investor sentiment towards the euro zone's more indebted countries – was at 178 bps after hitting 179.5 bps the day before, its highest level since June 8.