Inflation-plagued European bonds set to post record annual loss

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(Bloomberg) – European bonds fell, extending their worst year on record, as signs of lingering inflation rekindled worries about how much further the central bank will have to raise interest rates.

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German 10- and 5-year yields hit new 11-year highs, while risk-sensitive Italian bonds underperformed. Data on Friday showed Spanish headline inflation slowed in December, but an indicator of underlying price increases accelerated to 6.9%, the highest since 2002.

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The prospect of tighter monetary policy has bruised fixed income markets this year, with a Bloomberg Index of Euro-denominated investment-grade debt down more than 16% in 2022, the biggest loss ever. data going back to 1998.

Investors fear that policymakers will be forced to raise rates more aggressively to bring inflation in the region back to its 2% target. Keeping the European Central Bank’s key rate at a restrictive level would reduce inflation over time, Governing Council member Yannis Stournaras said in an op-ed for Greek newspaper Parapolitika.

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Traders added to their rate hike bets, betting that the ECB will raise its key rate to 3.59% by mid-2023. The yield on German 10-year bonds rose 11 basis points to 2.55%. The five-year yield jumped 10 basis points to 2.56%.

The ECB is also expected to start shrinking its balance sheet in March, ending years of accommodative monetary policy that has limited borrowing costs. This is just as governments are poised to increase bond issuance to fund programs designed to shield the region from an energy crisis.

—With the help of Libby Cherry.

(Price update, adds ECB comment in fourth paragraph.)