ECB rate expectations force up Greek and Italian borrowing costs

Borrowing costs for southern eurozone governments jumped close to pre-pandemic highs yesterday as investors adjusted to signs that the European Central Bank could raise interest rates as soon as this year in response to the global wave of inflation.

The ECB has trodden a careful line on the prospect of rate rises for several months as inflation has persistently risen, promising to keep financing conditions favourable until the eurozone economy rebounds from the pandemic.

But while the bank had continued to forecast that inflation would drop below its 2 per cent target over the medium term, Christine Lagarde signalled a “hawkish” shift last week by refusing for the first time to rule out a rate rise this year. The ECB president pointed to “unanimous concern” on the bank’s governing council over record eurozone inflation of 5.1 per cent in January.

At the weekend, Klaas Knot, head of the Dutch central bank, became the first ECB council member to say publicly that it should raise rates this year, warning that eurozone inflation would stay at 4 per cent for most of 2022. He called on the ECB to end net bond purchases “as soon as possible” in preparation for raising rates in the fourth quarter.

In response, a drop in eurozone bond prices sent the yield on Italian 10-year bonds up 0.1 percentage points to 1.84 per cent — back to levels reached in April 2020 after the pandemic hit.

The spread between Italian 10-year borrowing costs and those of Germany — a key measure of stress in eurozone bond markets — rose to 1.63 percentage points, its highest level since July 2020.

The drop was even greater in Greek 10-year bonds. Their yield rose 0.3 percentage points to 2.55 per cent — the highest level since June 2019. Selling pressure was widespread and Spanish 10-year yields rose above 1.1 per cent for the first time for almost three years.

Analysts said the bond market was adjusting to the increased likelihood that the ECB could bring net asset purchases to an end in the next few months, opening the door to its first interest rate rise for more than a decade.

“We are ending a period of negative rates — even Greek bond yields turned negative last year — and we are seeing a repositioning of the market,” said Carsten Brzeski at ING.

However, he said investors seemed to have “moved completely to the other extreme” by pricing in an ECB rate rise by June, adding the earliest he could imagine such a move was September.

Selling in Italian, Greek and Spanish debt eased later after Lagarde played down the chances of a sudden shift by saying there was “no need to rush to any premature conclusion at this point in time — the outlook is way too uncertain”. She told the European Parliament: “There are no signals that inflation will be persistently and significantly above our target over the medium term.”