European debt market hit by historic sell-off after rate rise bets

Europe’s bond market is on course for its worst month on record as investors have bet on big rate rises from the European Central Bank and Bank of England at a time of unprecedented inflation.

The region’s market for high-grade government and corporate debt posted a fall of 5.3 per cent in the month to Tuesday, the biggest drop since the Bloomberg Pan-European Aggregate Total Return index began in 1999. The decline has been broad, with UK, German and French debt all hit by heavy selling in a reversal of July’s gains.

The continent’s bond markets have been knocked as investors brace for more aggressive central bank rate rises in the face of surging food and fuel prices triggered by Russia’s war in Ukraine.

The selling picked up speed on Wednesday after a fresh round of data showed the rate of consumer price growth in the euro area hit a record high of 9.1 per cent in August. The report underlined how high inflation is becoming embedded more broadly across the economy.

The higher than expected inflation figure puts further pressure on the ECB to accelerate the pace of interest rate rises when policymakers next meet in September. The central bank in July raised its main interest rate for the first time in more than a decade but economists expect it will need to pursue further increases as it battles intense inflation. The BoE is engaged in a similar effort to quell surging inflation in Britain, which is running at the highest level in more than 40 years.

“The one single factor that’s driven bond yields higher in August is the explosion of energy prices in Europe,” said Antoine Bouvet, senior rates strategist at ING.

This month, investors ramped up their expectations of interest rate rises from the ECB and BoE as energy prices continued to increase. Markets expect the ECB’s borrowing costs to hit 2.1 per cent by March from zero currently while the BoE is being priced to raise rates to 4.1 per cent in March from a current level of 1.75 per cent, according to Bloomberg data based on pricing in money markets.

“Clearly the hawks have the momentum in their favour,” said Bouvet.

Germany’s central bank president Joachim Nagel has said that soaring inflation will require “a strong [ECB] interest rate hike in September”.

Analysts at JPMorgan, Goldman Sachs and Bank of America all said on Wednesday that they now expect the ECB to raise rates by 0.75 percentage points at next week’s meeting in an attempt to cool inflation. The last time the central bank raised its deposit rate by such a large margin was in 1999.

“Even if inflation does pass its peak, the central banks are going to remain hawkish,” said Richard McGuire, head of rates strategy at Rabobank.

The yield on Germany’s benchmark 10-year Bund has risen more than 0.7 percentage points to 1.54 per cent in August, its biggest monthly jump since 1990. The yield on the UK’s 10-year gilt has climbed from 1.8 per cent at the start of August, to 2.8 per cent on Wednesday.

The prospect of steep borrowing costs has also triggered worries about a potential recession across Europe and the UK next year, with some expecting central banks to be forced to cut interest rates come spring.

“Everything is aligned in the same direction and it all spells disaster for the consumer,” said McGuire.

Additional reporting by Ian Johnston