The rise in consumer prices prompted monetary policy reactions from the Bank of England and, belatedly but firmly, from the European Central Bank. Economies are reopening after pandemic shutdowns, especially in tourism-focused southern European countries. Eurozone gross domestic product in the second quarter rose 0.7%, well above forecasts, while UK GDP rose 0.8% in the first quarter.
It’s not quite a Goldilocks scenario, but at least the market bears have stopped grumbling. German 10-year Bund yields fell below 1%, UK gilts fell back below 2% and, perhaps most importantly, Italian yields fell below 3%.
No European summer would be complete without Italian political melodrama, with the collapse of the technocratic government led by Mario Draghi last month. But all is not lost as reassuring remarks from Giorgia Meloni, the right-wing Brethren of Italy leader and favorite to be the next prime minister, have bolstered expectations that the next administration will still stick to Italy’s fiscal rules. European Union. Although there is no room for complacency, there appear to be fewer risks to European unity than in previous episodes of Italian political instability.
So there is a repricing in European government bond yields, which were judged to have been too bullish in the first half of 2022 and are now easing amid a rebalancing of underweight positions in investors’ portfolios.
This may be an unexpected result after the ECB ended the era of negative interest rates with a surprise 50 basis point hike on July 21. interest rate. Market prices for which the ECB deposit rate is expected a year from now have fallen to less than 1%, half of what they were a few months ago.
When Italy’s 10-year yield soared above 4% in mid-June, it led to an emergency ECB meeting. In the absence of something more scientific, this seems to be the monetary authorities’ sore point for the sustainability of Italian debt. Central bank support since early June could be close to 10 billion euros, Bloomberg News reported on Tuesday; channeling this amount of reinvestment from the pandemic bond purchase program into Italy appears to have helped lower the country’s borrowing costs. The decline in yields on the Italian bond curve by around 100 basis points since then will make for a much happier summer in Brussels and Rome.
Germany currently appears to be the most vulnerable economy in the eurozone, after failing to grow in the second quarter. It must wean itself off Russian hydrocarbons, just as the inflation that is biting German consumers is eroding retail sales. Avoiding recession while thwarting inflationary pressures will prove particularly tricky for Europe’s largest economy.
Naturally, cross-readings from investors indicate that the ECB will ultimately not raise rates as much as expected. So while German 10-year yields have halved in recent weeks, two-year yields, more sensitive to central bank policy, have fallen to less than 0.2% from more than 1.2% six weeks ago.
Falling yields from Germany, Europe’s benchmark borrower, are having a ripple effect across Europe as they translate into cheaper funding across the board, including for the an 800 billion euro ($820 billion) pandemic next generation stimulus from the EU, a quarter of which is earmarked for Italy.
Across the Channel, the BOE is expected to match the ECB on Thursday with a more aggressive half-point hike to 1.75%, its sixth straight increase. Inflation, already at a 40-year high of 9.4%, should head for 12% by winter. But this first-quarter growth outcome is likely to be the high point for the foreseeable future, with the economy expected to contract slightly in the second quarter and then stagnate through 2023.
UK 10-year yields have fallen 90 basis points in recent weeks. These lenient terms may not persist, as Foreign Secretary Liz Truss, the front runner in the Tory leadership race to replace Boris Johnson as Prime Minister, has promised substantial immediate tax cuts and an increase in expenses.
This will likely lead to increased government debt issuance, just as the BOE plans to trim its bond portfolio by 866 billion pounds ($1.06 trillion) with active market sales of gilts, as well than not reinvesting maturing debt accumulated during quantitative easing. Nevertheless, the gilt market should be able to absorb the increased supply without too much trouble.
The club of yields below 1-2-3% is a relaxed place for European governments to see their respective 10-year bond yields, even if recent market movements reflect a less optimistic economic backdrop. If only summer never ended.
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Market Strategist for Haitong Securities in London.
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