July 20 (Reuters) - Swings in oil prices fueled a moderately volatile session for European government bonds on Monday, and inflation-sensitive markets fully priced two additional ECB rate hikes by early 2027.
Bond prices ended little changed but earlier rose solidly, the latest instance of traders focusing on the risk that rising energy costs could rekindle inflation and strengthen the case for further European Central Bank tightening.
As Monday's European session wrapped up, oil prices were steady, pulling back from earlier highs as price pressure from hopes of renewed U.S.-Iran negotiations was countered by Yemen's Houthis declaring a naval blockade against Saudi Arabia.
Likewise German two-year government bond yields, sensitive to expectations for policy rates, reversed earlier gains and were down one basis point (bp) at 2.77% after reaching 2.8174%, their highest level since July 2024.
Investors widely expect the ECB to hold rates steady while avoiding commitments on the future course of interest rates, and analysts said trading was relatively muted.
“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.
Money markets indicated the ECB deposit rate at 2.66% in December and 2.73% in February 2027 , up 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 front end of the euro yield curve, a dynamic that dominated market moves throughout March, April and May, has resurfaced in recent trading.
Germany’s 10-year government bond yield, the euro area’s benchmark, was up 1 bp at 3.14%. It reached 3.20% in mid-May, its highest level since May 2011.
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 rose 1.5 bps to 3.96%.
The yield gap between Italian government bonds and bunds 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, Colin Barr and Nick Zieminski
Source: Reuters