European government bond markets surged the most in years while stocks also rallied as investors bet that interest rates on both sides of the Atlantic would soon peak.
The European Central Bank and the Bank of England both raised rates by half a percentage point on Thursday, with the BoE expressing optimism inflation would fall below its 2 per cent target by the end of next year. The ECB benchmark deposit rate is now 2.5 per cent, while the BoE’s rate has risen to 4 per cent.
The dual European rate rises came a day after Federal Reserve chief Jay Powell signalled that the US was winning its own battle against soaring inflation and the Fed shifted to the slower pace of a 0.25 percentage point increase.
The yield on 10-year German bonds dropped 0.23 percentage points to 2.07 per cent, as investors piled into the market in the biggest rally on the region’s benchmark debt for more than a decade.
Yields on riskier Italian 10-year bonds fell 0.4 percentage points to 3.90 per cent, while US Treasuries also extended a rally on the back of Powell’s remarks.
“Markets are taking a victory lap on what looks like co-ordinated ‘light at the end of the tunnel’ signalling from central banks,” said Charlie McElligott, analyst at Nomura. “[Central banks] have thrown gasoline on the fire.”
The market moves came despite a pledge by Christine Lagarde of another half percentage point increase in March and a warning by the ECB president that eurozone inflation remained “far too high”.
“We know we have ground to cover, we know we are not done,” Lagarde said. She added that rate-setters already had enough evidence to be confident that a further significant rate rise would be needed since underlying price pressures had not yet started to come down.
The eurozone’s central bank has so far increased borrowing costs by 3 percentage points — a smaller increase than the UK and US central banks.
The ECB said it would “evaluate the subsequent path of its monetary policy” after March — language that some market participants took to suggest that interest rates could be nearing a peak.
But Lagarde made it clear that, while the pace of rate increases could slow from May onwards, it was unlikely that the ECB would be ready to pause by then.
“The question is how much to hike further beyond March, not whether to hike further,” said James Rossiter, head of global macro strategy at TD Securities.
Since December, the eurozone economy has proved more resilient than expected, aided by warmer weather and government support to help households and businesses cope with soaring energy bills.
While stronger growth has been welcomed by policymakers, it will make it harder for them to tame underlying price pressures and return inflation to their 2 per cent goal.
Data published this week showed the eurozone headline rate of inflation fell more than expected, from 9.2 per cent in the year to December to 8.5 per cent last month. But eurozone core inflation — which excludes changes in food and energy prices, and is seen as a better indicator of longer-term price pressures — was unchanged at an all-time high of 5.2 per cent.
In contrast with the ECB’s pledge to increase rates in March, the BoE suggested UK interest rates might peak at the country’s new rate of 4 per cent, below the 4.5 per cent previously expected by financial markets.
There was no attempt by the BoE to suggest financial markets are misguided in expecting interest rate cuts later this year. But MPC members warned “that the risks to inflation are skewed significantly to the upside”.
The BoE’s new central inflation forecast shows it thinks price rises will ease quickly from December’s 10.5 per cent annual rate to a level under 4 per cent by the end of the year. Inflation is forecast to drop well below the BoE’s 2 per cent target in 2024.
As investors moved into UK bonds, the yield on the 10-year gilt slipped 0.35 percentage points to 2.99 per cent. London’s FTSE 100 was up 0.8 per cent.