An inflation problem that’s starting to look intractable is making euro-zone bonds a risky bet as policymakers turn up the volume on hawkish warnings.
(Bloomberg) — An inflation problem that’s starting to look intractable is making euro-zone bonds a risky bet as policymakers turn up the volume on hawkish warnings.
J.P.Morgan Asset Management and BlackRock Inc. are among the firms bracing for another selloff in longer-dated bonds. They reckon markets are underestimating the risk that inflation in the region — once the epicenter of falling prices — will remain high for longer.
That would be another twist for European bonds, which have been highly volatile this year. The yield on German two-year bonds rose to a 15-year high at 3.4% in early March on expectation the European Central Bank would raise interest rates aggressively and tumbled to a year-to-date low close to 2% less than two weeks later during the banking crisis. The rate has since risen to 2.9%.
“The markets are desperately hoping that Goldilocks is on her way back, bringing with her low inflation. That’s deluded,” said Karen Ward, chief market strategist for EMEA at J.P. Morgan Asset Management. “I don’t think yields where they are now properly compensate investors for inflation and interest-rate risks.”
Consumer prices in the euro zone fell to 6.9% last month from 8.5% in February as energy prices eased, but the core reading hit a new record. Still, the German bond yield curve remains inverted, with the spread between two- and 10-year rates at about minus 40 basis points, suggesting markets are more worried about an economic slump than inflation.
For Ward, price pressures in Europe are becoming more entrenched as governments move away from extreme post-crisis austerity and turn to the costly fight to slow climate change. She says the ECB may have to raise interest rates to as high as 4% to fight inflation, and the 10-year German bond yield could climb to 3% in coming months.
Inflation will be a bigger problem in Europe than in the US this year, said James Rossiter, the head of global macro strategy at TD Securities. He forecasts core inflation in the region will outpace that of G4 economies as an improvement in supply-chain bottlenecks has not yet been reflected in consumer prices.
Traders ratcheted up bets that the ECB will extend its hiking cycle through September after Governing Council member Robert Holzmann warned stubbornly high inflation warrants a 50 basis-point increase in interest rates in May. Money markets currently price the deposit rate peaking at about 3.7%.
Wei Li, the global chief investment strategist at BlackRock, also expects the German yield curve to steepen as inflation in Europe will remain above pre-pandemic levels due to a tight labor market. She favors very short-dated bonds over the long end of the curve.
“Our expectation is that the ECB is more determined than the Fed to bring inflation back to target,” said Li. “We think yields will go higher and inflation risk premia will return.”
(Updates 2-10 year yield spread in 5th paragraph. An earlier version corrected the maturity of German bond yield.)
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