Inflation fears send euro zone yields to multi-week highs

Euro zone bond yields hit multi-week highs on Tuesday after a survey ​showed euro zone consumers expecting higher inflation, prompting markets to raise the likelihood of a ​hike in interest rates by the European Central Bank in ‌the ​coming months.

Euro zone bond yields hit multi-week highs on Tuesday after a survey ​showed euro zone consumers expecting higher inflation, prompting markets to raise the likelihood of a ​hike in interest rates by the European Central Bank in ‌the ​coming months. Germany's rate-sensitive two-year yield rose to 2.649%, its highest since April 7, while the euro zone benchmark, Germany's 10-year yield reached 3.08%, again a two-week high. It was last 3 bps higher at 3.07%.

Both are still below their levels hit in late March ‌before the U.S. and Iran agreed a ceasefire, but they have been ticking steadily higher in recent sessions as the continued effective closure of the Strait of Hormuz means energy prices continue to grind higher. Hopes for an imminent resolution to the two-month U.S. and Israeli war on Iran, which has disrupted energy supplies and fuelled inflation,have been fading and a U.S. official said President Donald Trump was ‌unhappy with the latest Iranian proposal to end the war.

Investors now see a greater chance of the ECB raising interest rates in an effort to prevent the higher oil ‌and gas prices spilling over into broader price rises, despite the negative impact this would have on economic growth. Those fears were underscored on Tuesday by the ECB survey which showed inflation expectations for one year ahead had jumped to 4.0% in March from 2.5% a month earlier, while bets for three years out rose to 3.0% from 2.5%, both well above the ECB's 2% target.

ECB FOCUSED ON INFLATION, NOT GROWTH Complicating the picture, a separate survey showed ⁠economic growth is ​faltering, though the market focus was firmly on ⁠the inflation expectations survey.

"The market is more worried about inflation than growth, and this is partly because if you look historically you find the ECB gives four times as much weight to inflation as it does to growth, whereas ⁠the Fed gives equal weight," said Mohit Kumar, chief Europe economist at Jefferies. ECB policymakers are expected to keep rates on hold when they meet on Thursday as they await more evidence about the duration and ​extent of the energy-induced inflation shock, but hikes are expected to be on the table by their next decision in June.

Markets are currently pricing in around an 85% ⁠chance that the ECB raises rates by its June meeting and are fully pricing in two 25 bp rate hikes by its September meeting. That pricing is slightly higher than it was before the survey was published. "In June, they (the ⁠ECB) ​will also have staff forecasts (of economic indicators including growth and inflation) and typically it's easier for them to make a decision at such meetings because they can justify it based on the forecasts," said Kumar.

"Though our base case is we shouldn't get a rate hike, because we believe that we are moving towards a deal and in three months' time, we see ⁠oil going to $80 to $85 a barrel, but of course, it's uncertain, and geopolitics is always difficult to predict." Brent crude futures for June were 3% higher at $111.8.

Other euro zone yields moved ⁠higher alongside Germany's. Italy's two-year yield rose 8 ⁠bps to 2.89%, its highest in three weeks, and its 10-year yield gained 7 bps to 3.91%, again a three-week high. Other central banks are also meeting this week. The Bank of Japan kept rates unchanged on Tuesday but struck a hawkish tone, sending 10-year Japanese government bond yields ‌up towards a 29-year peak.

The ‌Federal Reserve concludes its meeting on Wednesday and the Bank of England on Thursday.