- Yields on Eurozone government bonds have generally risen sharply, influenced by the renewed escalation of geopolitical tensions in the Middle East and the stalled peace talks between the US and Iran. Traders now estimate that the probability of the European Central Bank (ECB) implementing three rate hikes by the end of the year has exceeded 50%.
- The repricing of monetary market expectations for tightening policies has significantly intensified, with the ECB's deposit rate now expected to rise to 2.66% by December. This implies not only two confirmed rate hikes within the year but also a probability of about 65% for a third hike.
- Germany's two-year government bond yield (DE2YT=RR), which is highly sensitive to short-term policy rates, rose by 5 basis points to 2.67% on Wednesday. This reflects growing investor concerns about the long-term nature of energy-driven inflation and the potential demand for increased fiscal spending, which is putting pressure on the bond market.
Monetary Market Repricing of Deposit Rate Path
With the latest swap market data disclosed, the yield curve of the Eurozone sovereign debt market has risen across the board. Traders are now targeting a December deposit rate of 2.66%, marking a significant marginal change from previous relatively moderate expectations. Market pricing indicates a 90% probability of a first rate hike at the policy meeting on June 11. According to the latest micro-survey by Reuters of several authoritative economists, the ECB is expected to raise the deposit rate to 2.25% at the upcoming meeting and may further tighten in September. Policymakers face a difficult balance between secondary inflation pressures driven by energy costs and weakening economic fundamentals within the Eurozone. If core inflation data continues to exceed expectations, the span of the rate hike cycle may exceed the market's previous general expectations.
Geopolitical Escalation Blocks Inflation Relief Path
The direct trigger for the current rise in bond market yields comes from severe geopolitical turmoil. Recent peace talks between the US and Iran in the Gulf region have stalled, and investors' previous optimistic scenario of an agreement and the reopening of the Strait of Hormuz has not materialized. Instead, the Gulf situation significantly worsened on Wednesday, with Iran's missile attack damaging Kuwait's airport, while the US military conducted targeted airstrikes near the Strait of Hormuz in retaliation. These conflicts have directly cut off global supply chain expectations for a decline in the costs of commodities like crude oil, making it impossible for energy price-driven inflation pressures to be substantially alleviated in the short term. If shipping through the Strait of Hormuz continues to be obstructed, the revaluation of supply chain costs will further elevate the future core inflation center.
Fiscal Spending Expansion Risks Weigh on Bond Market
As a result, government bonds in many European countries have been sold off. In addition to Germany's two-year government bond yield rising by 5 basis points to 2.67%, Italy's 10-year government bond yield (IT10Y) also recorded a significant change to 3.24%. Yoram Lustig, Head of Global Investment Solutions at T. Rowe Price, pointed out that this is the third major energy crisis Europe has faced since 2000. From previous public health events and geopolitical conflicts to the current Iranian situation, each external crisis outbreak requires massive fiscal funds from governments to support damaged industries and subsidize consumers. Long-term high fiscal spending suggests that the supply scale of sovereign bonds may continue to expand in the future, which will be a potential factor putting long-term pressure on the Eurozone bond market.
Long-term Yield Curve and Macroeconomic Outlook
In the medium to long term, the ECB's interest rate decisions depend not only on short-term geopolitical events but also on the deep-seated constraints of core inflation stickiness within the Eurozone. If core inflation does not fall as expected in the second half of the year, market pricing of the long-term neutral rate will face comprehensive revisions. Currently, the market has gradually downplayed the previously optimistic options of rate cuts or halting tightening in its pricing. For sovereign bond investors, future portfolio returns will be highly dependent on the duration of supply-side fluctuations and the strength of fiscal policy cooperation. This cross-asset transmission mechanism is causing volatility in the European fixed income market to remain at historically high levels. If macroeconomic uncertainty continues to suppress risk appetite, the valuation adjustment of Eurozone assets may further transmit to credit assets.
