Bond yields hit multi-year highs as traders brace for new ECB rate-hike cycle

By Harry Robertson

LONDON, Sept 10 (Reuters) - Traders in the euro area were bracing for interest rate hikes well into next year on Thursday as the European Central Bank hiked borrowing costs and increased its inflation forecast, just as oil prices jumped again due to the Iran war.

The combination of a hawkish ECB and rising energy costs knocked euro zone markets as the outlook darkened, with bond yields hitting multi-year highs. Stocks and the euro fell.

Germany's 10-year bond yield rose to its highest level since 2011. France's 30-year yield hit levels last seen in 2003.

U.S. and UK bond yields rose to their highest in around two decades or more, as global energy prices jumped.

The ECB lifted its key rate to 2.5%, from 2.25%, as it seeks to ensure a jump in energy prices stemming from the U.S.-Iran war does not spread through the euro zone economy.

It said inflation was set to remain well above target for an "extended period", with price growth still expected to run at 3% this year but now seen at 2.5% in 2027, up from a forecast of 2.3% in June.

The hawkish tone was a surprise to many analysts anticipating the ECB to signal a wait-and-see approach.

Carmignac fund manager Aymeric Guedy said ECB President Christine Lagarde's tough tone on inflation meant there was little to stop euro zone bonds being caught up in Thursday's global selloff.

"Hawkishness in terms of the forecasts, as well as nothing in speech to change this narrative, has validated the market behavior that rates have to follow energy prices," Guedy said.

RATE-HIKE BETS JUMP

Oil prices rose more than 4% on Thursday to an almost four-month high above $105 a barrel, adding to investor concern about a more sustained pickup in inflation. European gas prices hit their highest since 2022.

The jump in energy prices and ECB statement exacerbated pressure on debt markets as traders raised their bets on further hikes.

Money markets now price in around 85 bps of further monetary tightening by end-2027, up from just under 70 bps before the announcement. A rate hike by December was fully priced in.

Bloomberg reported that ECB officials expect further hikes and could raise rates again as soon as October, adding to a sharp rise in shorter-dated bond yields.

Europe's broad STOXX 600 equity index fell 0.6% while the euro slipped 0.1%.

"The ECB has used this meeting to acknowledge a stronger economy and a more persistent inflation outlook than it expected just a few months ago," said Aberdeen economist Felix Feather, adding that the ECB seems less confident that 2.5% is the end-point of the cycle.

UNDER PRESSURE

Thursday's sharp rise in bond yields will be felt throughout economies and markets, raising costs on government borrowing and mortgages, while potentially dimming the appeal of stocks.

It comes at a sensitive political moment in the euro zone: France is heading for a divisive election next year amid battles over its high budget deficit and the far-right is gaining ground in Germany.

French and Italian bonds were under pressure, with the gap between French and German 10-year bond yields - a measure of the risk premium attached to French debt - rising to its highest since 2012 at more than 90 bps.

Global bond yields have risen to multi-year highs in recent weeks as rising energy prices have layered concerns about inflation on top of worries that governments are not doing enough to reduce high levels of public debt.

"The inflation risks may be rising and a further hike in December may be more likely than not, but the ECB still needs to tread carefully," said Deutsche Bank’s chief European economist Mark Wall.

"The economy has been resilient over the last six months, but rapidly rising gas prices mean the negative supply shock is building. It will eventually hurt growth."

(Reporting by Harry Robertson; Editing by Amanda Cooper, Dhara Ranasinghe and Toby Chopra)