(Bloomberg) -- Europe’s bonds slid after policy makers delivered an unprecedented interest-rate increase to tackle searing inflation, with traders anticipating a further announcement on government deposits that would curb demand for short-term debt.
The yield on two-year German bonds, among the most sensitive to changes in policy, rose as much as 21 basis points to 1.31% after the ECB’s President Christine Lagarde said it will publish a statement on government deposits shortly. Concern over a 0% interest cap on such deposits has been a key driver of money market rates in recent days.
The announcement “will be very interesting for both the cash (bills) and repo market,” said Piet Philip Christiansen, chief strategist at Danske Bank A/S. The flattening of European yield curves happened on the back of Lagarde’s comments about the announcement, he said.
That also reversed a widening in the so-called asset-swap spread, with the premium two-year German debt demands over equivalent interest-rate swaps falling eight basis points to 95 basis points.
ECB rules cap most euro-zone government deposits at central banks at 0%. Bloomberg News previously reported fiscal authorities in Europe were considering options to reduce their cash holdings in favor of short-term securities if the cap remained when the ECB’s key rate turned positive.
The ECB raised its deposit rate by 75 basis points, as predicted by the majority of economists surveyed by Bloomberg. Expectations of a jumbo hike had built in the weeks prior to the meeting, with Governing Council members highlighting the need to act quickly to tame inflation running at an annual rate of over 9%. That’s despite gas shortages that threaten to push the economy into recession.
“Not too long ago, a 0.75% increase in the policy rate would have been considered a complete hiking cycle in the euro area,” said Gurpreet Gill, a macro strategist for global fixed income at Goldman Sachs Asset Management. “Today’s further outsized rate increase is in response to an upside surprise in recent inflation data and a more hawkish inflation outlook ahead.”
Traders are now pricing 60 basis points of hikes for the ECB’s October meeting, putting the odds of another three-quarter point increase at 40%.
The rate hike failed to provide support to the euro, which slipped below parity with the dollar, even though the ECB pledged “several” further increases. It traded down as much as 0.7% to $0.9932, as the dollar surged after Federal Reserve Chair Jerome Powell said the US central bank will not flinch in its efforts to curb inflation “until the job is done.”
“The reference to frontloading may suggest a slower pace of tightening ahead,” said Francesco Pesole, a strategist at ING Groep NV. “In a way, it is still the gas story playing a role, simply because it has caused some de-linking of euro-dollar with its short-term rate dynamics and monetary policy divergence.”
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