Euro zone yields climb after ECB’s Knot signals 50-bp hike possible

Euro zone government bond yields extended their rise while money markets ramped up rate-hike expectations on Tuesday, after European Central Bank official Klaas Knot signalled a 50-basis-point rate increase was possible in July.

Meanwhile, investors turned to risky assets away from safe-haven bonds on optimism about an easing in Chinas crackdowns on its technology sector and the spread of COVID-19.

Germany‘s 10-year government bond yield, the euro zone’s benchmark, rose 10.5 basis points (bps) to 1.05%, its highest since May 11 and not far off its highest since August 2014 at 1.189% reached on May 9..

Germanys 2-year bond yield rose 13 bps to 0.26%.

The introduction of the 6/24 Schatz short-dated German government bond has produced abysmal results, with the second-lowest cover of any Schatz auction, the record being a new issue in May 2018.

The ECB should raise its key interest rate by 25 basis points in July but should not yet rule out a bigger increase, Knot told Dutch TV programme College Tour.

Money markets are currently pricing in around 105 bps of ECB rate hikes by year-end, from 95 bps late on Monday.

“Once the ECB starts committing to hiking rates, those expectations should come down, so we shouldnt over-interpret this comment (from Knot),” DZ Bank rates strategist Sophia Oertmann said.

“We think a 25 bps rate hike is the most likely scenario for July,” she added.

Concerns about the economy continued to weigh after weak data from China and the United States.

ECB policymaker Francois Villeroy de Galhau said on Monday the euro‘s weakness on currency markets could threaten the central bank’s efforts to steer inflation towards its target.

“Villeroy opened a new front in the expectations war yesterday by expressing concerns about the inflation impact of a lower euro,” ING analysts said.

Italys 10-year government bond yield rose 12 bps to 2.958%, with the spread between German and Italian 10-year yields widening to 191 bps.

Finance Minister Christian Lindner said Germany could not support a softening of EU fiscal rules, which “should be more realistic and effective”.

The war in Ukraine overshadowed concerns about the sustainability of Southern European countries‘ public debts, with investors expecting the European Commission not to apply the bloc’s debt reduction rules next year due to the conflict.

However, less stringent regulation would enable most indebted countries to fulfil EU obligations without hurting the economic recovery.

“We have no concern about Italian debt sustainability in the near term. But the ECBs reluctance to disclose details of its purported financial fragmentation facility risks unnerving investors,” ING analysts said, while forecasting the spread between Italian and German yields to widen to 250 bps.

ECB officials said recently the central bank didnt discuss any concrete instruments to avoid fragmentation – yield spread widening between core and periphery, which could hamper the transmission mechanism of monetary policy – but they were ready to act.

(Reporting by Stefano Rebaudo Additional reporting by Dhara Ranasinghe; Editing by Mark Potter)