European bondholders are coming to terms with the fact that this year's losses could go on for a long time.
After a chorus of central bankers warned investors that interest rates will rise more than expected, the bonds ended the year with one of the worst sell-offs in months. A fresh wave of selling looks to be on the way with traders already betting on another 130 basis points of hikes.
Money markets are expecting more rate hikes from the European Central Bank.
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After being seen as one of the world's most dovish policy makers, the European Central Bank has made their determination to quash double-digit inflation clear. The traders who had piled into the region's battered assets with a false sense of security were shocked.
The head of rates strategy at Bank of America Securities said that it is less controversial to see European yields reset higher in absolute terms.
The market responded quickly to the warnings from the European Central Bank. The investors increased their bets for a peak rate of 3.30%. The yield on 10-year Italian bonds has added more than 40 basis points, making for the worst week since June. The two-year note in Germany reached 2.50%.
The forecasts for inflation were revised up a lot by the European Central Bank. Consumer prices fell to 10.1% last month from a record 10.6%, but are still expected to average 3.4% and 2% over the next two decades. The target of the European Central Bank is 2%.
The managers of the region's government debt are still reeling from the worst year on record. The sector is down more than 15% this year, making it the biggest loss on record.
The uncompromising tone of the European Central Bank has made it possible for the bank to recommend that European yields rise closer to the US. The spread between German and US treasuries has narrowed in the past week.
There is some doubt that the level of tightening promised will be delivered. That is because soaring borrowing costs threaten to tip the region into a deeper recession, compounding the damage done by the energy crisis.
A market revolt could be triggered by higher interest rates at a time when government bond issuance is increasing. The clash could cause the ECB to retreat.
There will be a global recession in 2023 as central banks keep hiking.
The impact on Italy is concerning. The nation is one of Europe's most indebted economies and has been a beneficiary of the ultra-loose monetary policy of the European Central Bank.
The nation's yield premium over Germany increased last week for the first time since the early days of the Pandemic in April 2020.
"Overly aggressive monetary policy risks engineering a sharper recession and widening of peripheral spreads which will raise fragmentation risks." Christine Lagarde may have gone too far in trying to convey another half-point hike in February.
There are many reasons to be cautious over the bond market performance in the early part of the year.
The European Central Bank set out a plan to shrink its vast crisis-era debt holdings in order to remove a pillar of support from the market. Francois Villeroy de Galhau said that the central bank will allow 15 billion of bonds a month to mature from March.
As governments ramp up issuance to finance programs to protect their citizens from energy prices and a cost-of- living crisis, the net supply of bonds will be inflated. The lack of supply pressure in the US is one of the reasons to favor Treasuries over European debt.
Net European government bond supply is expected to hit 228 billion in the first quarter and as much as 557 billion over the course of the next five years, assuming reinvestments end in July or September at the latest, according to strategists at the French bank.
Fiscal easing in the face of high energy prices requires tighter monetary policy. There is inflation. A global strategist at Ostrum Asset Management said that deposit rates have a long way to go. Hawks are getting the upper hand.
James Hirai helped with the project.
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