Lagarde warns of the risk of energy inflation, expectations of the ECB's subsequent rate hike are heating up, European bond market sell-off intensifies

The Zhitong Finance App learned that the sell-off in the European bond market intensified further on Thursday. After raising interest rates, ECB President Lagarde warned that rising energy prices were increasing the risk of inflation. Combined with Brent crude oil breaking through $105 per barrel and European gas prices rising to the highest level since the end of 2022, investors further increased their bets on the ECB's subsequent rate hikes. The yield on German two-year treasury bonds once surged 12 basis points to 3.19%, the highest level in nearly three years.

The ECB raised interest rates by 25 basis points as expected by the market on Thursday. Lagarde said after the meeting that the latest developments in the Middle East conflict and the Russian-Ukrainian war “have further boosted the energy price path,” and that rising energy costs may gradually spread to core inflation and food prices. At the same time, the ECB warned that as the Middle East conflict continues to push up price pressure, inflation in the Eurozone is expected to be significantly higher than the 2% policy target “for a long period of time.” This statement further strengthened the market's expectations that the ECB will continue to tighten monetary policy.

The interest rate swap market has now fully taken into account the expectation that the ECB will raise interest rates three more times by the middle of next year, 25 basis points each time. At the same time, the probability that the central bank will raise interest rates again next month at the earliest is over 50%.

Patrick Ernst, macro investment strategist at J.P. Morgan Private Bank, said, “Raising interest rates again before the end of the year is no longer a small probability risk. Policymakers have made it clear that the risk of energy-driven inflation is still real.”

Energy prices have recently become one of the most important drivers of the European interest rate market. The price of Brent crude oil once surpassed $105 per barrel this week, while European gas prices rose to the highest level since the end of 2022, driving widespread sell-off in the global bond market.

Kenneth Broux, strategist at Société Générale, said that since July, “energy, especially natural gas, has almost become the only main trading line in the euro interest rate market.” He pointed out that judging from long-term inflation expectations, German treasury yields are currently at a high level, but unless energy prices stabilize, any rebound in the bond market may be difficult to sustain.

The European bond market sell-off is not limited to Germany. French treasury bonds are also under clear pressure. The yield premium on French 10-year treasury bonds compared to German treasury bonds during the same period once extended to 91 basis points, the highest level in the intraday market since 2012.

Recently, investors are increasingly concerned about France's fiscal deficit and uncertainty about the political outlook, causing the French government's financing costs to continue to be under pressure. Treasury bond yield spreads between France and Germany are generally regarded as an important measure of France's sovereign credit risk and market risk premiums. Their continued expansion reflects investors' demand for higher compensation for holding French bonds.

The British bond market has not been spared either. UK two-year Treasury yields rose 14 basis points to 4.84%, while 30-year Treasury yields rose to 5.92%, the highest level since 1998.

At the same time, traders have further raised their bets on the Bank of England's interest rate hike. At present, the market has taken into account the expectation that interest rates will increase by a total of 108 basis points by the end of next year, indicating that rising energy prices are reshaping the interest rate prospects of major European central banks.

Regarding the recent surge in global bond yields in general, Lagarde stressed that this “is not a problem unique to the Eurozone.” She said that the ECB is closely monitoring changes in the yield curve over the long term, and pointed out that there are many factors driving the rise in long-term interest rates, including increased debt issuance related to artificial intelligence investments.

Ed Hutchings, head of interest rates at Aviva Investors, believes that it is reasonable for the market to expect the ECB to continue to raise interest rates, but the current pricing may be somewhat excessive. “The market is right to think there will be more interest rate hikes,” he said. However, with the ECB already implementing two interest rate hikes and the market taking into account more than two interest rate hikes in the future, interest rate expectations “probably have gone too far.”