Markets price in two ECB rate hikes by early 2027 on inflation concerns

By Stefano Rebaudo

July 20 (Reuters) - German two-year government bond yields were roughly unchanged after rising to a two-year high early on Monday amid expectations that the European Central Bank will deliver two additional rate hikes by early 2027.

Euro area borrowing costs tracked moves in oil prices which pared their early rise and were last down 0.15% at $88 per barrel, after Iran's foreign ministry said negotiations with the U.S. could be pursued based on national interests. 

Germany’s 2-year yields <DE2YT=RR>, more sensitive to expectations for policy rates, were flat at 2.78%, after reaching 2.8174%, their highest level since July 2024.

Money markets indicated the ECB deposit rate at 2.67% in December and 2.75% in February 2027, from the current 2.25%. They also fully priced a rate hike in September.

Analysts flagged that the tight correlation between oil prices and the euro front-end, a dynamic that dominated market moves throughout March, April and May, has resurfaced in recent trading.

Germany’s 10-year government bond yield <DE10YT=RR>, the euro area’s benchmark, was up 1 basis point at 3.13%. It reached 3.20% in mid-May, its highest level since May 2011.

Market participants continued to expect the ECB to leave interest rates unchanged at its policy meeting later this week. 

“Despite the resurfacing tensions in the Middle East and rising oil prices, these remain somewhat below the June baseline assumptions and signs of second-round effects remain limited,” said Giada Giani, an economist at Citi.

Euro zone firms expect selling prices to rise more moderately and see a slowdown in wage growth, an ECB survey showed on Monday, adding to evidence that a recent energy-driven inflation surge has yet to generate second-round price impacts. 

"Crude oil prices are still well below the spring highs but refined products prices tell a different story as diesel and gasoline are trading like if oil was at $110/120," Societe Generale said.

"For the ECB, a saving grace is that this still mostly an oil story and not a gas/electricity one though prices are creeping higher there too."

Italy’s 10-year government bond yields <IT10YT=RR> rose 1.5 bps to 3.96%.

The yield gap between Italian government bonds and bunds <DE10IT10=RR> was at 80 bps. It was at 63 bps in February before the attack on Iran and hit 103.62 in late March, the widest since June 2025.

(Reporting by Stefano Rebaudo; Editing by Toby Chopra)