Bond Traders fear ECB Hawks when energy jitters return to Europe

Last week, traders and strategists were reminded of the fragility of Europe’s energy security and bond market risks.

After threats of strike in Australia, spot natural gas prices jumped almost 30% within a single day.

ING Groep NV (Rabobank), Saxo Bank (Denmark) and Rabobank A/S all recommend positioning yourself for a hawkish turn from the European Central Bank, as energy prices are once again on the rise. They say officials will be looking to prevent long-term inflation expectation from drifting higher.

Benjamin Schroeder is a senior rates strategist with ING. “Suddenly, some inflation alarms have rung again,” he said. Recent swings in natural gas prices highlight the risk of a supply disruption to the recent more benign inflation dynamics.

The ECB will release its own survey of inflation expectations on Monday. Energy prices affect a number of markets, including the UK which does not have natural gas storage. The nation will report inflation data on Tuesday.

While Europe has plenty of cold-weather supplies, it still pays four times as much as the US. It is also about twice what they paid before the pandemic. Last week, as energy prices soared, a market indicator of long-term expectations for inflation reached its highest level since 2010. Traders say that the ECB will find it difficult to justify a halt to the tightening cycle if the ECB’s forecasts are not revised downward.

Schroeder warned that ECB hawkishness may escalate in order to limit the risks of price-growth. He cautioned against rushing into curve-steepening bets — betting that the yields on longer-dated notes will rise faster than those of shorter notes. He warned that markets should not underestimate “the central bank’s resolve and persistence.”

The Russian invasion of Ukraine accelerated Europe’s dependence on imported liquefied gas. The reliance on Russian energy was a major factor in the inflationary surge that began last year. It is also likely to fuel future price pressures as the region is highly vulnerable to disruptions to the global energy markets.

The money markets currently place a 40% probability of a 25-basis point increase from the ECB for September. A further 66-basis points are priced in for next year. Rabobank echoed that the ECB would need to be “more determined” in order to combat inflation, given the risks of future energy price increases.

Lyn Graham Taylor, senior rates strategist at Rabobank, said that energy is a key issue for the ECB. He prefers to focus on European bond-steepening trading focused on the less-policy-sensitive 5- and 30-year curvatures — as opposed to the 2- and 10-year ones.

Saxo Bank A/S attributed the rise in market-based inflation to traders who have increased their energy prices.

Althea spinozzi, senior fixed-income strategist at Saxo Bank said that energy is the main factor in keeping inflation above the target set by the central bank. Natural gas will be in greater demand as winter approaches.

Spinozzi believes that the ECB will stay on hold longer than it would otherwise. She is a fan of the short end of the yield-curve, which she believes will flatten out until October.

State Street & Trust Co. believes that the ECB policy outlook will not be dramatically altered by the price increase, since the changes were not as drastic as those seen last year. Inflationary pressures are also continuing to fall elsewhere.

Tim Graf, head of EMEA’s macro strategy, said that if this was a solely energy price shock it shouldn’t force a too wide rethinking of the market pricing of policy rates.

Factor in the tightening of global food supply chains, extreme weather and WTI crude at a high of nine months and you have a host of factors that threaten to accelerate inflation.

Orla Garvey, senior fixed income portfolio manger at Federated Hermes, said that “parts of the market say the ECB must hike in September.”

A spike in headline inflation is a risk that’s underpriced.