Government bonds are sold off when interest rate expectations are higher


European and US government bonds sold off on Wednesday as investors upgraded their expectations of how much central banks will hike interest rates to curb inflation.

The moves, which were particularly pronounced in the UK and European markets, came on the eve of a multi-day economic symposium for policymakers in Jackson Hole, Wyoming. The event, hosted by the Federal Reserve’s Kansas City branch, will be closely watched by investors for signals from central bankers on the future direction and pace of monetary policy.

The yield on the two-year UK government bond, which is particularly sensitive to changes in interest rate expectations, rose 0.22 percentage points to 2.90 percent, reflecting a sharp fall in prices. The benchmark 10-year gilt yield rose 0.12 percentage points to 2.69 percent.

Those sharp moves came as pricing in money markets indicated investors expected the Bank of England to hike borrowing costs to nearly 3 percent by November, versus forecasts a week ago of 2.6 percent and a current base rate of 1.75 percent. Data released last week showed that UK inflation rose to a 40-year high in July.

Antoine Bouvet, senior rates strategist at ING, said the UK Debt Management Office’s announcement on Tuesday that it would sell £1.5 billion worth of short-dated gilts on Thursday added to the unease. The sale comes at a time when liquidity, or the ease of buying and selling bonds, has deteriorated due to summer holidays and heightened economic uncertainty in European bond markets.

“It’s far from huge, but it shows that the impact of adding supply to an illiquid, very nervous market can be quite significant,” Bouvet said.

The more volatile gilt movements become, the worse liquidity gets, he added. “It’s a bit of a chicken and egg scenario.”

Euro-zone short-dated bond prices also fell, with the yield on the two-year German Bund rising 0.08 percentage point to 0.90 percent and the equivalent Italian debt rising 0.05 percentage point to 1.87 percent.

Investors on Wednesday were expecting the European Central Bank to hike interest rates by 1 percentage point through October from a current deposit rate of zero. The ECB raised interest rates by half a percentage point in July, the first hike in more than a decade.

The sharp rise in bond yields and interest rate expectations shows how a rise in natural gas prices in Europe and the UK is raising concerns about already elevated levels of inflation. The European gas benchmark rose 15 percent on Wednesday to a new closing high of €300 per megawatt-hour, while the UK price rose 13 percent to £5.58 per spa. This compares to €200 or £3.49 in early August.

In the US, the yield on the benchmark 10-year Treasury bill hit its highest level in nearly two months, rising 0.06 percentage point to 3.11 percent ahead of the central bank conference in Jackson Hole that begins Thursday. The two-year yield rose 0.07 percentage points to 3.40 percent.

The event is often used by policymakers to guide their future policy stance, and investors will be alert to how aggressively the central bank looks to raise interest rates later in the year.

“Caution is warranted in equity markets as aggressive policies aimed at curbing inflation are expected to continue despite fresh signs of a slowdown in the US economy,” said Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.

Minneapolis Fed Chairman Neel Kashkari, previously perceived as a more dovish Federal Reserve policymaker, said Tuesday night that the combination of “maximum employment” and “very high inflation” made the Fed’s approach “very clear: We need to tighten monetary policy to balance things.”

US stock markets were more subdued. Wall Street’s stock index, the S&P 500, gave up some of its early gains to close 0.3 percent higher on weak volumes. The tech-heavy Nasdaq Composite rose 0.4 percent.

Europe’s regional Stoxx 600 rose 0.2 percent. In Asian markets, Hong Kong’s Hang Seng closed 1.2 percent and China’s mainland CSI 300 Gauge closed 1.9 percent as concerns mounted over the indebtedness of the country’s huge property market.


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