European bonds slide on prospect of inflation reaching 2% by 2025

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The prospect of an interest rate hike by the European Central Bank earlier than many analysts had expected hit eurozone bonds on Friday, pushing German borrowing costs to their highest for more than two months.

The moves came after the Financial Times announced that the ECB was planning to meet its 2% inflation target by 2025, according to unpublished internal models that imply that a rate hike from above levels record could occur as early as the end of 2023. It would be long before many. await economists.

The ECB said in a statement after the publication of the FT article that the idea of ​​raising rates in 2023 was “not in line with our forecast”.

The central bank also denied the FT report that ECB chief economist Philip Lane said in a private conversation with German economists on Wednesday that “the eurozone will hit 2% inflation soon after the end of the ECB’s projection horizon “. Two people involved in the appeal told the FT that was what they believed he said.

German bonds fell on Friday, pushing up the country’s 10-year bond yield – a benchmark for debt markets across the money block – by 0.03 percentage point to minus 0.27%, the highest since beginning of July. Italian 10-year yields, a key barometer of sentiment towards riskier debt, climbed 0.05 percentage point to 0.74%. The euro rose briefly against the dollar before falling again.

The prospect of a rate hike in 2023 does not surprise all market players. Futures markets linked to short-term interest rates were already forecasting an increase to minus 0.4 percent in the fall of the same year. Despite this, some investors are sensitive to any suggestion that concerns over inflation could lead to an anticipated tightening of monetary policy.

“It is perhaps not surprising that the ECB has models that predict that it will eventually hit its inflation target, even if this is far from the case,” said Antoine Bouvet, senior strategist in rates at ING. “But this comes at a time when the current inflation numbers are increasing and there is more talk about inflation in general. This definitely struck a chord with some investors and is what drove the market movement. “

Central bank officials downplayed the importance of the ECB’s “medium-term baseline scenario” that Lane referred to in the private call. This model looks five years ahead of the forecasts published by the ECB and is generally not made public.

Spain’s central bank governor Pablo Hernandez de Cos, who sits on the ECB’s governing council, said on Friday that the idea of ​​a rate hike at the end of 2023 was “clearly ahead of what the market expects today.” hui “. He pointed out that the inflation swap markets have risen recently but still do not include inflation of 2 percent in the years to come.

But other national central bank leaders on the ECB board have publicly stated that the ECB may still raise its inflation expectations. “Some of us think that in reality the forecast is too pessimistic,” Irishman Gabriel Makhlouf said during an online event: “Some of us think that at present the forecast reaching 1.5% inflation in 2023 is too low. “

Latvian Martins Kazaks said in a Bloomberg interview published on Friday: “While Covid doesn’t surprise on the negative side, there is some uptick for the medium-term inflation outlook.”

Eurozone inflation peaked at 3% in August, but the ECB’s official forecast indicates that it will subside next year and reach 1.5% in 2023. It is expected to release 2024 forecasts. in December, which will be closely watched by investors to see how close it is to its target.

“We believe it is unlikely, but not impossible, that the ECB will sustainably meet its inflation target by 2025, and that would be good news, not bad news – including for risky assets – if it was, ”said Krishna Guha, vice president president of Evercore ISI.

“The key here is the degree of protection against a hawkish policy error based on overly optimistic forecasts provided by the ECB’s new forward-looking stance,” Guha said, adding that a rate hike was unlikely in 2023.

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