Euro zone sovereign bond yields remained close to multi-year highs on Thursday as investors prepared for the European Central Bank’s latest interest rate decision. Rising energy prices and renewed inflation concerns have strengthened expectations for tighter monetary policy.
ECB Expected to Raise Interest Rates
The European Central Bank is widely expected to raise interest rates by 25 basis points at its Governing Council meeting in Frankfurt later on Thursday.
Such a move would lift the ECB’s benchmark deposit facility rate to 2.50%.
Expectations surrounding the decision have kept borrowing costs elevated across the euro area. Germany’s policy-sensitive two-year Schatz yield traded near 3.037%, close to its highest level in around two years.
Meanwhile, the benchmark German 10-year Bund yield remained firm at approximately 3.432%. It stayed just below the 15-year high reached earlier in the week.
Investors are now waiting for the ECB’s updated economic projections and comments from President Christine Lagarde for further clues about the direction of monetary policy.
Market Expectations Shift Toward Tighter ECB Policy
Expectations for Thursday’s ECB meeting have changed significantly over recent months.
As recently as mid-summer, markets largely expected the central bank to leave interest rates unchanged. However, renewed inflation pressures have caused investors to reassess that outlook.
One of the main concerns is the sharp rise in energy prices.
Brent crude has been trading above $100 per barrel following an escalation of military tensions in the Persian Gulf. Higher oil prices have increased inflation risks for European economies that depend heavily on imported energy.
Euro zone inflation accelerated to 3.3% in August, with energy prices rising 14.3%. The increase has made it more difficult for ECB policymakers to adopt a more accommodative stance.
Higher Inflation Could Keep ECB Policy Restrictive
Institutional investors will closely examine the ECB’s latest staff projections for any upward revisions to medium-term inflation forecasts.
Higher projected Harmonised Index of Consumer Prices, or HICP, inflation could signal that restrictive monetary policy will remain in place for longer.
ECB officials are particularly concerned that persistent inflation could eventually feed into wage growth and create broader second-round price pressures.
As a result, interest rates may need to stay elevated through the autumn even if immediate energy-price pressures begin to ease.
Lagarde’s Guidance Could Drive the Next Market Move
Markets have largely priced in a 25-basis-point rate increase. Therefore, the rate decision itself may not be the biggest source of market volatility.
Instead, investors will focus heavily on Christine Lagarde’s press conference following the announcement.
Traders will look for indications of whether the expected September rate increase is simply a response to temporary energy-price pressures or the beginning of a broader monetary tightening cycle.
Any suggestion that additional rate hikes could follow may place further upward pressure on European bond yields.
On the other hand, a more cautious message could encourage markets to reduce expectations for further tightening.
U.S. CPI Report Becomes the Next Major Test
Attention will quickly shift from Frankfurt to the United States, where investors are awaiting Friday’s Consumer Price Index report.
The U.S. inflation data will be particularly important following the stronger-than-expected nonfarm payrolls report released last week.
A hotter-than-expected CPI reading could strengthen expectations for tighter Federal Reserve policy and push government bond yields higher across global markets.
Such an outcome could also increase volatility ahead of the Federal Reserve’s September 15-16 Federal Open Market Committee meeting.
With both the ECB and Federal Reserve facing renewed inflation pressures, global bond markets could remain highly sensitive to incoming economic data and central bank guidance.
