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Market Extra: European bond yields tumble on expectations peak rates near despite ECB pledge on further hikes

European government bonds joined a global rally Thurday, dropping sharply despite the European Central Bank delivering an expected half percentage point interest rate hike and saying it intends to raise by another half point in March.

While the ECB said it would need to keep raising interest rates “significantly at a steady pace” to get inflation back down to its 2% target, market participants appeared convinced the hiking cycle is nearing an end, sending the yield on the policy-sensitive 2-year German government bond

down 20.5 basis points to 2.484% and the 10-year yield

down 23.5 basis points to 2.048%.

Earlier Thurday, the Bank of England lifted its key rate by half a percentage point and also signaled it wasn’t finished tightening. In separate news conferences, ECB President Christine Lagarde and BOE Governor Andrew Bailey both signaled further tightening to come.

“While the tone of both press conferences would appear to suggest that both central banks have further to go in raising rates, markets appear to be taking the view that we’re near a peak as far as rates are concerned, and even if they aren’t done yet, they are close, sending bond yields falling sharply across the board,” said Michael Hewson, chief market analyst at CMC Markets UK, in a note.

“We know we are not done,” Lagarde told reporters.

In its policy statement announcing Thursday’s rate hike, the ECB said its rate-setting Governing Council intends to raise rates by another half-point in March and that further moves would be data-dependent. It also said it would “stay the course in raising interest rates significantly at a steady pace and in keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to its 2% medium-term target.”

The rally in European bonds follows on a Treasury rally from Wednesday, after Federal Reserve Chair Jerome Powell pushed back against market expectations for a rate cut before the end of the year, but also said a “disinflationary process” had begun.

“There are certainly a lot of assumptions in what has transpired this afternoon, but today’s market price action tells a different story to what we’ve heard from all three central banks in the last few hours,” Hewson said. “While central banks are essentially saying we have further to go on raising rates, markets are saying we don’t believe you, and even if you do hike again, you’ll have to cut again by year end.”

For her part, Lagarde said a disinflationary process hadn’t begun in the eurozone. But analysts said Lagarde, much like Powell, didn’t offer a convincing pushback against expectations the hiking cycle is near its end.

Analysts, for example, seized on Lagarde’s description of the inflation outlook as “more balanced.”

The ECB surprised market participants in December, with policy makers warning that they should prepare for a series of rate hikes to come. Since then, the eurozone’s economic backdrop has brightened, with mild winter weather leading to a fall in energy prices and averting a severe crunch that had been feared as a result of Russia’s invasion of Ukraine.

But the improved economic picture is a double-edge sword for the ECB, noted analysts at Danske Bank. While headline inflation has eased, underlying measures remain sticky. Unlike the U.S., core inflation, which strips out volatile food and energy prices, continued to rise in the eurozone, with the December rate climbing 5.2% from 5% in November.

See: ‘Decidedly less hawkish’: 4 takeaways from Powell’s press conference as Fed hikes rates again

The euro

was down 0.7% at $1.0915 versus the U.S. dollar.

The euro and other major currencies fell sharply versus the U.S. dollar last year. The shared currency has rebounded in 2023 and the dollar has fallen back versus major rivals as traders bet the Fed is nearing the end of the hiking cycle and may deliver rate cuts by year-end in defiance of the central bank’s forecasts.

European equities rose, with the Stoxx Europe 600

gaining 1.4%.

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