European Inflation Spike Leaves Bond Market with a Sour Aftertaste

Strategists from Citigroup Inc. to Societe Generale SA and Danske Bank A/S say that the sigh of relief in Europe’s sovereign bond market over cooling inflation may prove to be short-lived.

As inflation rates in various countries came in lower than expected during the first week of 2023, the last data point from the euro area on Friday carried a bitter detail that served as a reminder that European Central Bank officials are most likely going to follow through on their aggressive tightening stance. This is despite the fact that German 10-year bond yields posted their biggest weekly decline on record.

Charles Diebel, head of fixed income at Mediolanum, believes that the recent rally in European markets is due more to short covering than anything else. "One swallow does not a summer make," he said. "I think it's too early to sit there and say that European inflation has turned the corner."

After last year's record-breaking losses in government bonds, traders are hoping for signs that inflation may be easing off. Price growth spiraled out of control last year, leaving many investors scrambling for answers. If inflation does start to slow down, it could provide some much-needed relief for the bond market.

The euro area's headline inflation reading for December came in at 9.2%, below expectations. This follows a string of improved data for individual countries, as well as falling natural gas prices.

However, the core measure of inflation quickened to a record 5.2%, which has kept the ECB hawkish and has analysts pointing to renewed weakness in debt markets.

Citi has revised its first-quarter German 10-year yield target up by 20 basis points to 2.55%. Societe Generale sees the rate approaching 3% at its peak, which would surpass the 11-year high set in the latter days of 2022.

The yield on German notes fell last week to 2.21%, down 11 basis points from the previous week. The decline came after US Treasuries surged on Friday, following slower-than-anticipated wage data and an unexpectedly weak services-sector indicator.

Citi strategists warned on Friday that the recent New Year rally looks fragile. They argued that the market is making the same mistake as it did in late November and early December by placing too much emphasis on falling headline inflation.

ECB President Christine Lagarde warned investors last month that the Governing Council would hike rates more than was then priced in. Policymakers lifted their inflation forecasts last month to an average of 3.4% in 2024 and 2.3% in 2025, still above their 2% target.

Inflation in the Euro-Zone has dropped sharply, but this may be masking underlying pressures. Economists are watching to see if this is a temporary blip or a sign of something more serious.

Chris Jeffrey, head of rates and inflation at Legal and General Investment Management, does not believe that the headline inflation drop is a reason to invest in bonds.

"I don't think these changes in headline CPI will have much impact," he said. He's waiting to see signs of a faltering labor market and higher inflation-adjusted yields before taking a long position in euro-zone government debt. In the coming week, traders will be turning their focus to gauges of industrial production for insight into the economy's resilience.

Diebel, at Mediolanum, said that while he is "mildly" positive on government bonds, he is nonetheless focusing exposure on longer-dated securities, such as Austria's 100-year bond. He believes that these types of bonds will be less affected by when exactly the ECB's key rate peaks. He went on to say that pressure on shorter maturities looks set to continue for now.

Oliver Eichmann, head of rates and fixed income for Europe, the Middle East, and Africa at DWS, believes that there is little chance of a strong rally in the near future. However, he believes that last year’s slump has created attractive opportunities.

"We don't see a major drop in yields from current levels over the next 12 months," he said. "There will probably be a lot of volatility, but we don't see a further sell-off here."

Money-market traders are predicting that the ECB will raise interest rates by around 145 basis points by the middle of 2023.Policymakers were quick to warn against reading too much into Friday's softer inflation numbers.

Although the latest price data from Europe is encouraging, Mario Centeno, a member of the European Central Bank's Governing Council, said that borrowing costs must still be increased. Philip Lane, the ECB's Chief Economist, said that the latest data is not conclusive as to the inflationary trend.

ECB's Lane Says Price Pressure Won't Vanish If Energy Costs EaseECB Executive Board member Philip Lane said on Tuesday that inflationary pressures in the euro zone are unlikely to disappear even if energy prices ease.

"Even if energy prices were to fall back, which is hard to predict, underlying inflationary pressures are unlikely to vanish," Lane said in a speech in Dublin.

"There are good reasons to think that the current period of low inflation will not be prolonged," he added.

Piet Christiansen, chief strategist at Danske Bank, said that while it may seem like the worst of the hawkishness is behind us and the stagflation may not be as severe as anticipated, the ECB is not near its tightening end.