Europe’s sovereign bonds on edge

Rather than a Fed rate hike, concern is more over the fall in commodity prices and the impact on outlook

Euro-region sovereign bonds may weather higher US interest rates this week. While the Federal Reserve’s policy decision is the market’s main focus in coming days, it’s the fall in commodity prices and how that will weigh on the inflation outlook that might drive bonds higher in the euro area.

With crude oil prices plummeting to their lowest since 2008 on Friday (December 11), deflationary pressures will undercut the policies of the European Central Bank. A measure of the region’s future inflation expectations fell to its lowest close in almost two months, signalling that the ECB is unlikely to veer from its policy stance of monetary easing.

Benchmark German 10year bunds climbed, with yields posting their biggest weekly decline in two months. That’s a reversal from the surge in yields seen after ECB President Mario Draghi’s deposit rate cut and quantitative easing boost on December 3 fell short of some investors’ expectations.

“Everybody is convinced the Fed will hike rates but really the question is what comes after that,” said Elwin de Groot, a senior market economist at Rabobank International in Utrecht, Netherlands. Even though the ECB decision “was quite a negative surprise for the market, for now we are still in this situation where, because commodity prices are coming down, the inflation prospects have not improved. At least in the short term, that will continue to weigh on yields.”

Biggest drop

Germany’s 10-year bund yield fell 14 basis points, or 0.14 percentage point, to 0.54 per cent last week as of the 5pm London close on Friday. That’s the biggest drop since the week ended October 2. The 1 per cent security due in August 2025 rose 1.315, or €13.15 per €1,000 ($1,100) face amount, to 104.32.

A report due December 16 will show that the annual rate of inflation in the euro area was unchanged at 0.1 per cent in November, according to the median estimate of a Bloomberg survey of economists. That is far below the ECB’s inflation target of just under 2 per cent, a level not achieved since early 2013.

Oil prices have slumped to levels last seen during the global financial crisis, partly as a result of the Organisation of Petroleum Exporting Countries’ strategy to defend market share against highercost producers. The group’s production rose to a threeyear high in November, it said in a report on December 10.

European bonds may also be supported by dovish rhetoric from Janet Yellen. Investors have said they expect the Fed chair to signal a gradual trajectory for future interest rate increases, even as the US central bank is widely expected on December 16 to move off record-low borrowing costs.