Bond rout gathers pace after ECB hike

No-brainer: The ECB hiked as expected and raised its outlook for inflation for the next two years. It didn't explicitly lean into needing more hikes ... it doesn't need to do that right now because bonds are selling off so hard and markets are pricing in about 3 more hikes through the middle of 2027. Staff forecasts indicate headline inflation running a little higher in 2027 and 2028 than they forecast in June, while growth estimates for this year and next were also stronger thanks to the better-than-expected resilience of the euro area economy. It's also due to fiscal loosening. 

This year's growth outlook was raised to +0.9% from a forecast +0.8% in June, while for 2027 it was raised to 1.4% from 1.2%. For 2027 and 2028, inflation forecast is revised up to 2.5% and 2.1%, respectively, while core inflation is expected to come in at 2.5%, 2.6% and 2.3% over the forecast period. 

ECB president Christine Lagarde noted that inflation will be "longer lasting than we anticipated", and warned of "upside risks" to inflation, which sounded hawkish, but I guess merely reflected the staff projections. A rate hike at this meeting, she said, was a "no-brainer".

Overall, this looks a bit hawkish – it doesn't lean into hawkish market pricing as such, but also didn't slam the door shut – they've left it open to do more and the market is saying 'look you will probably hike again'. Clearly the ECB is prepared to do more if it has to but as stated in my notes earlier the hike today takes policy to the top end of neutral and it's unclear how they would justify going restrictive since a) it's still primarily a supply shock and b) underlying inflation pressures remain benign and the risk of second order impacts appears relatively muted for the time being, and c) the economy has held up well but it's not running hot. Market pricing for bond yields does not necessarily reflect the reality of central bank thinking.

Bond yields backed up some more after the announcement as oil prices shot higher with Brent to $106 as the Iran-backed Houthis seized a Yemeni Red Sea port. German Bund yields ripped higher and importantly the spread between French and German yields moved out to the widest since the Eurozone sovereign debt crisis, pushing above 90bps, highlighting the next problem for the ECB – controlling spreads. When does the convo move on from hikes to thinking about asset purchases to tame spreads?

UK gilt yields have gone out sharply to a fresh 19-year high for the 10yr yield +10bps at 5.37%, while the 10yr US Treasury yield is +8bps higher to 4.92%...I think we hit 5%, the market wants to test it. At the front end US 2yr yields jumped +10bps to 4.53% as traders raised expectations for the Fed to hike rates next week – up to 67% from 60%.

Just after the ECB decision US wholesale inflation came out showing a rise of +0.4% in August as expected. That sent the annual rise in PPI at +5.4%, while core rose +0.3% on month with the annual rate of inflation rising from +4.2% in July to +4.7% in August. Final demand goods advanced 1.1%, and prices for final demand services increased 0.1%.

Oil prices ripped higher with Brent crude pushing the $105 envelope where an upside breach of $106 could trigger a rapid move to $110. US WTI cleared a milestone to trade above $100. Stock markets in Europe nursed another day of losses with yields and crude moving out once again, while US futures turned negative. In FX, the euro fell as USD rallied across the board but by late afternoon at the European close the move had retracted with EURUSD backing up from just under 1.16 where it seems to have found some near-term support to try to reclaim the 200-day line at 1.16334...interesting doji candle forming at this key moving average. Similar picture for cable which fell back to below 1.35 before it recaptured this handle at kicked on back to its 20-day line at 1.3560 where it seems to have met some resistance. Quite a bit of indecision evident while this move in bonds shakes out and we get a better handle on what's going on in oil and we have a big data risk event coming up...

US CPI inflation is the big test tomorrow and just a small shift in the reading could alter the picture for the Fed. Leaving aside why Fed officials can be swayed by a 0.1ppt difference for a single month, it nevertheless means there is an unusually high degree of uncertainty and risk associated with this event. Headline inflation is seen at +0.3% MoM, with the annual rate holding steady at +3.4% in August. Core is seen at +0.2% and slowing slightly to +2.4% YoY. I had a look at some of the reasons for the move in bonds earlier today here and in this morning's quick take.