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US Inflation Optimism Hits Euro Markets, German Bonds Wary

Euro-area bonds rally on US inflation data, ECB rate cut prospects uncertain with market eyeing Fed's next moves.

By Athena Xu

5/16, 02:10 EDT

Key Takeaway

  • US inflation data drives optimism in European markets, yet annual CPI at 3.4% signals a cautious path ahead.
  • ECB's rate cut prospects remain uncertain with potential for less than three cuts, closely watching Fed's policy moves.
  • German bonds face resistance at 2.90% yield despite market optimism, with interventions possibly affecting yield spreads unfavorably.

Market Response to Inflation Data

European markets opened with a positive outlook following a favorable reaction in the US Treasury market to the latest inflation data. The US bond market experienced a surge, driven by the perception that inflation pressures are moderating, although annual CPI at 3.4% remains significantly above the Federal Reserve's target. This development suggests that while the direction of inflation is encouraging, the journey back to the target inflation rate is still ongoing. German bonds, in response, saw a rally, reflecting the global market's reaction to the US inflation data, albeit with an understanding that the potential for further gains might be limited.

ECB's Rate Cut Prospects

The European Central Bank (ECB) is at a crossroads with its monetary policy, as market participants have priced in nearly three full rate cuts for the year. However, ECB President Christine Lagarde has indicated that the path to these rate cuts is uncertain, with the possibility that fewer than three reductions could occur. The future of ECB's policy adjustments is closely tied to the Federal Reserve's actions, with the timing and nature of the Fed's policy loosening being a significant factor for the ECB's decisions. This situation places euro-area bonds in a precarious position, as their rally potential is capped by the current market pricing of a 75 basis point policy reduction for the year.

German Bonds and Market Dynamics

The German bond market is experiencing its own set of challenges, with the two-year yield struggling to break below the 2.90% mark despite several attempts. This resistance level underscores the market's skepticism about the potential for significant gains in German bonds, even as the 10-year bund yields have slightly increased to 2.42%. The market's lukewarm enthusiasm towards German securities is further complicated by the German Finance Agency's increased intervention in the repo market, which, while aimed at easing liquidity, may inadvertently be narrowing the yield spread between German and Italian government bonds to the detriment of German taxpayers.

Street Views

  • Ven Ram, Bloomberg (Neutral on German bonds):

    "The surge in US bonds was essentially driven by relief that price pressures aren’t completely untamed -— the moves weren’t heralding the likely rapid return of inflation to target... German bonds duly rallied in sympathy, but the scope for those gains to extend from here is thin."

Management Quotes

  • Christine Lagarde, ECB President:

    "The path beyond a first rate cut in the summer is far from certain."