Euro zone bond yields fall after BoE recession warning

German government bond yields fell on Thursday after the Bank of England (BoE) raised rates but warned about recession risks, just as investors assess whether the euro zone market is fairly pricing the European Central Bank's (ECB) future rate hike path.


Reuters | Updated: 04-08-2022 20:56 IST | Created: 04-08-2022 20:56 IST
Euro zone bond yields fall after BoE recession warning

German government bond yields fell on Thursday after the Bank of England (BoE) raised rates but warned about recession risks, just as investors assess whether the euro zone market is fairly pricing the European Central Bank's (ECB) future rate hike path. The 50-basis-point (bp) increase from the BoE had been expected by most economists as central banks around the world scramble to contain the surge in prices.

Britain's 10-year gilt yield was down 4 basis points (bps) to 1.88%. Germany's 10-year government bond yield, the bloc's benchmark, dropped 6 bps to 0.812%. It was 1 bp lower just before the BoE announcement.

According to Rohan Khanna, research strategist at UBS, a spillover from gilts to euro zone bonds was expected as "the Bank of England, like other major central banks, is facing stubborn inflation" amid recession risks. The Bund 10-year yield fell from over 1.8% in mid-June to its lowest in almost four months at 0.68% on Monday as investors scaled back ECB rate hike bets.

Hawkish comments from U.S. Federal Reserve officials returned investors' attention to further monetary tightening on Wednesday, boosting euro zone yields. "The current pricing (of future ECB rate hikes) by euro zone government bonds may not look very misplaced," said Khanna.

"Markets are currently pricing 100 bps of hikes by year-end. Such a move would take rates at the lower end of the neutral rate range, which is an excellent place to be," in the current economic backdrop, he added. The ECB has said it aims to raise rates towards the neutral level, where it is neither stimulating nor slowing economic growth. The neutral rate is unobservable but most policymakers put it somewhere between 1% and 2%.

Italian bonds outperformed their peers, with the 10-year yield falling 9 bps to 2.93%. The closely watched spread between Italian and German 10-year yields tightened to 212 bps. "As the bar for flexible PEPP reinvestments into BTPs seems rather low, we expect more tightening potential in coming sessions," Commerzbank analysts said in a research note.

The so-called first line of defence against fragmentation – Pandemic Emergency Purchase Programme (PEPP) reinvestments – showed significant support for the peripheral bond markets of Italy and Spain during July, analysts said, mentioning ECB data. The central bank pledged to fight fragmentation, or excessive spread widening that might hamper monetary policy transmission across the currency bloc.

In July, the Italian government of Mario Draghi collapsed and the Italian-German yield spread widened up to 260 bps. "We think PEPP reinvestment is the tool the ECB will use if the Italian-German spread should widen up to around 250 bps," UBS' Khanna said.

"At 300 bps or more, they might activate the TPI, but not if political instability is behind the spread widening." The ECB announced a couple of weeks ago its Transmission Protection Instrument (TPI), a bond purchase scheme aimed at helping more indebted countries and preventing financial fragmentation.

(This story has not been edited by Devdiscourse staff and is auto-generated from a syndicated feed.)

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