European Bonds Jump as Energy Prices Drop on Iran Ceasefire

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(Bloomberg) — German and UK bonds surged after energy prices sank following a ceasefire between the US and Iran, prompting traders to slash bets on rate hikes this year. 

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Yields on 10-year bunds and gilts tumbled to a three-week low after the US and Iran agreed to a two-week truce, which includes Tehran allowing ships to pass through the Strait of Hormuz. Traders aggressively pared wagers on interest-rate rises and now see the European Central Bank delivering two quarter-point increases and the Bank of England just one increase this year.

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Markets had been pricing stable or falling rates in Europe this year before the war upended the outlook for inflation. European bonds were particularly hard hit by the conflict because of the continent’s reliance on energy imports, which leaves it highly vulnerable to soaring oil and gas prices.

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Inflation expectations fell sharply alongside oil and gas prices Wednesday, spurring the bid in bonds. A proxy for euro area price growth over the next 10 years dropped to 2.1%, almost fully erasing the sharp jump since the start of the war. Swaps now imply around a 30% chance that the ECB will hike rates by a quarter-point later this month, down from 70% on Tuesday.

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“If the ceasefire gets extended, an ECB rate hike in April, and beyond, becomes unlikely,” said Christoph Rieger, head of fixed income and credit research at Commerzbank AG.

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Risks Remain

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German 10-year bond yields were 16 basis points lower at 2.92% and Italian peers were down 28 basis points at 3.68%. That tightened the spread between the pair — a gauge of the region’s risk — by 12 basis points to 76 basis points, the narrowest it has been since mid-March. 

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While falling energy costs should ease the pressure on policymakers to act to keep inflation in check, some investors say it is too soon to sound the all-clear.

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“A lot of negotiation needs to take place before we can say this is over,” said Matthew Amis, an investment manager at Aberdeen. “Markets are going to be even more sensitive to headline risk over the next two weeks, therefore this doesn’t feel like a one way move in yields just yet. “

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What Bloomberg Strategists Say:

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“While traders will have a close eye on the durability of the ceasefire and direction of oil and gas prices from here, they will also be keen to hear how ECB policymakers assess the latest developments. Given traders are still essentially pricing in a hike by June, there is still plenty of room for those wagers to unwind if the messaging coalesces around a wait-and-see approach.”

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— Conor Cooper, Macro Squawk. Click here to read the full analysis.

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UK 10-year yields tumbled 20 basis points to 4.70%, while their more interest-rate sensitive two-year peers fell 25 basis points. Money markets also trimmed bets on Bank of England interest-rate hikes, with swaps implying 33 basis points of increases this year, down from almost 60 basis points on Tuesday, while the probability of a hike later this month has almost vanished. 

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“For now, it’s a celebratory mood out there,” said Kathleen Brooks, research director at XTB. However, she cautioned that if the ceasefire is broken or if ships do not start moving through the Strait of Hormuz quickly, then “market sentiment could shift.”

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—With assistance from Alice Atkins.

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