Traders Bet on Europe Inflation Jump, But No Guarantee on Hikes

(Bloomberg) --

Bond traders in Europe got a fresh reason to worry over record inflation, even as prospects of monetary policy tightening this year remain murky amid the Ukraine war.

Germany's 10-year yield adjusted for inflation headed on Wednesday for its lowest close on record after euro-area price gains quickened to an all-time high in February. Traders have gone back and forth between seeing a quarter-point European Central Bank rate increase this year, or next. That's a far cry from two weeks ago, when they were all but certain policy makers would deliver a such a hike by September.

War in Ukraine is forcing markets to confront the risk of stagflation as they weigh the potential of slowing growth against surging energy and food prices. It's also complicating the picture for Governing Council members who may have to rethink their playbook when they gather for a policy decision next week.

“Positioning has become incredibly challenging these days leaving European government bond investors caught between a rock and a hard place,” said Althea Spinozzi, fixed income strategist at Saxo Bank A/S. “The market looks certain that a war in Ukraine means a dovish ECB for longer. I beg to differ, in that inflation is definitely going to rise, forcing the ECB to intervene.”

Bond Whiplash

European bond yields have been whiplashed in the past two days. They slumped on Tuesday, led by German 10-year nominal rates that fell by the most since 2011, as bets on hikes evaporated. They turned around a day later as investors grappled with warnings from the likes of Deutsche Bank, which said rising oil and natural gas prices are pushing the euro lower and causing “a vicious inflationary spiral.”

German 10-year breakeven rates -- a measure of average inflation expectations across the next decade -- climbed to 2.31%, within a whisker of the all-time high set more than a decade ago.

“There is a real risk that markets will get surprised by a hawkish ECB next week,” said Piet Christiansen, chief strategist at Danske Bank. “It's a resilient economy, with tight labor markets heading into the war.”

Euro-zone inflation quickened more than economists estimated last month, hitting a record 5.8% as energy remained the main driver. It's set to head higher still, with Russia's invasion of Ukraine threatening to further stoke oil and natural gas prices -- Germany is already predicting an average headline rate of 5% for 2022.

Europe Gas Rises 60% With Traders Backing Away From Russia Deals

Stagflation Shock

The war has shifted the focus at the ECB, where officials are now more likely to hold off on cementing a timetable to wind down asset purchases as they weigh up the knock-on effects of the fighting for Europe.

The invasion will stoke already high inflation and slow economic activity, according to ECB Vice President Luis de Guindos, who said he saw no risk of stagflation in the region.

Meanwhile, Governing Council member Mario Centeno, who also heads Portugal's central bank, said in a Bloomberg interview this week that he's “convinced” the economy will keep its traction, even though “a scenario close to stagflation” can't be ruled out.

New projections due next week will offer some insight into where euro-area growth and inflation are headed. The crisis will reduce output by between 0.3 to 0.4 percentage point this year, according to projections presented by ECB Chief Economist Philip Lane last week.

“We're one shock away from stagflation, so there is a risk that negative growth becomes the baseline scenario now,” said Frederik Ducrozet, global strategist at Banque Pictet & Cie SA. In terms of the ECB's possible responses, he adds, “either the situation eventually improves and they will hike, or things get worse and they could do more quantitative easing albeit while opening up the possibility of hiking in the meantime.”