The resilience of German short-end government bond yields to energy shocks is strengthening, which means they are more likely to move lower over the longer term.
Over the past week, European natural gas prices have continued to climb, breaking above the multi-year high set in September. Yet volatility at the short end of the German yield curve has been minimal.
In fact, the correlation between German two-year government bond yields and natural gas prices has fallen to its lowest level since the outbreak of the Iran conflict. The short end of the eurozone yield curve is becoming increasingly stable.
With France in political turmoil and the market believing that the policy rate is already at the upper bound of the neutral range, traders are reluctant to add to bets on European Central Bank monetary tightening.
With inventories low ahead of winter and no clear sign of resolution in either the Iran or Ukraine conflicts, natural gas prices have room to rise further.
However, if prices continue to climb, the market will interpret this more as a negative drag on economic growth rather than a pure inflation shock, the latter of which typically requires central banks to respond with rate hikes.
Sustained increases in energy prices will weigh on economic growth, and eventually traders will lower current pricing (the market expects roughly 75 basis points of ECB rate hikes through September next year), pulling short-end yields lower.
A political risk premium still exists at the long end of the eurozone yield curve, and these changes will partially reverse the curve flattening that has occurred since the outbreak of the Iran conflict.
Comments