Euro Soars, Bonds Slide as Traders Add Bets on ECB Hikes in 2022

(Bloomberg) -- Traders brought forward wagers for interest-rate hikes from the European Central Bank, lifting the common currency and spurring a selloff across the region's bond markets.

Money markets are betting the ECB will deliver a total of 40 basis points of hikes through December, compared with 25 basis points on Wednesday. The repricing comes as President Christine Lagarde said risks to the inflation outlook were tilted to the upside and didn't repeat earlier statements that interest-rates hikes are unlikely in 2022.

The euro jumped above $1.14 for the first time in two weeks as traders recalibrated their expectations. Italian bonds led the selloff, with 10-year yields surging more than 20 basis points, set for the biggest increase since the pandemic turmoil in 2020. The bank left its key rate unchanged at minus 0.5% on Thursday, as expected.

“This is hawkish Lagarde, 2022 is in play,” said Danske Bank's chief strategist Piet PH Christiansen. “The press conference is in a stark contrast to the decision.”

The change in gears from the ECB is a sign for some investors that policy makers will act sooner than previously expected to temper accelerating inflation, joining other major central banks including the Bank of England in raising rates.

So far, the ECB is seen as a laggard in signaling an end to the unprecedented stimulus unleashed during the pandemic, especially considering the hawkish tilt from the Federal Reserve last month that forced markets globally to price in a more aggressive path of tightening.

Hawks were also emboldened by data earlier this week that showed euro-area consumer prices in January rose a record 5.1% from a year earlier.

German two-year yields, the most sensitive to rate policy, climbed as much as 13 basis points to minus 0.32%, the highest since 2015. Five-year rates neared 0%, after the yield on equivalent French debt crossed above the threshold this week.

But there's also a sense that the market is testing how much of a selloff the ECB is willing to tolerate before it begins to dial back expectations. The premium on Italian bond yields over equivalent German debt -- a key barometer of risk in the region -- rose to the highest since September 2020.

While Lagarde acknowledged in the press conference that yields have gone up, she said spreads hadn't widened much.

“The path of least resistance is that peripheral spreads move to the point at which the ECB does start to get worried,” said Mike Riddell, a portfolio manager at Allianz Global Investors. While nobody knows where that point is, “we're confident that the market will move to test it,” he said.