By Yoruk Bahceli and Dhara Ranasinghe
LONDON (Reuters) - Euro zone government bonds yields soared on Thursday as money markets rushed to price in more than four rate hikes from the ECB this year as president Christine Lagarde chose not to repeat her past comment that a 2022 rate hike was very unlikely.
The ECB kept policy on hold but at its post-meeting news conference, Lagarde acknowledged the bloc's inflationary situation has changed following a record high January reading.
Asked if her long-standing view that the ECB was "very unlikely" to raise rates this year remained in force, Lagarde said the bank would assess conditions very carefully and there were "no pledges without conditionalities", adding the bank will be "data-dependent".
Markets took that to mean Lagarde was not ruling out rate hikes this year, which money markets have long priced in even though they have been at odds with the bank's policy stance and economic projections.
Following the press conference, sources told Reuters a sizable minority of ECB policymakers had already wanted to dial back stimulus at this meeting, and a decision in March now looks more likely.
Money markets raced to bring forward bets on a first ECB rate hike to June, pricing in a more than 90% chance of a 10 bps move, and more than 40 bps worth of hikes by the end of the year..
"Lagarde has opened the door to hikes this year," said ING senior rates strategist Antoine Bouvet.
"She hinted that the inflation forecasts will be revised higher in March and the market is concluding that the conditions set out in the ECB’s forward guidance will be met at some point in 2022."
"The implication is that it might end (quantitative easing) earlier than signalled and that it will hike this year," he added.
The repricing of rate hike bets sent bond yields sharply higher, led by Southern Europe, the primary beneficiaries of ECB stimulus.
Italy's 10-year bond yield jumped 23 bps to 1.64%, the highest since May 2020 and its biggest daily surge since March 2020, when the COVID crisis rattled world markets. Bond yields move inversely to prices. Two-year yields turned positive for the first time since August 2020.
The closely-watched gap between 10-year Italian and German yields widened to 148 bps, the most in a week.
GRAPHIC - Italian bond yields surge
https://fingfx.thomsonreuters.com/gfx/mkt/myvmnjazkpr/italy%20feb%203.png
In Germany, five-year bond yields led the sell-off, up 16 bps to -0.07%. Ten-year yields rose 12 bps to 0.15%, the highest since early 2019. Both were set for their biggest daily rise since March 2020.
Two-year bond yields rose 14 bps to -0.322%, far above the ECB's policy rate of -0.50%, hitting their highest levels since 2015.
The sell-off pushed Germany's yield curve, measured by the gap between 10 and 30-year bond yields, to the flattest since 2008.
Yield curves have been flattening ahead of central bank policy tightening across major economies, with investors citing concerns that early hikes to stamp out inflation may hurt economic growth.
"Central banks must now put on the brakes to contain the inflation caused by overheating. This almost always results in a recession. And recessions have proved disinflationary," said Arne Petimezas, senior analyst at AFS Group.
"That's why 30-year-bonds have been doing so well."
Rate hike bets supported the euro, which shot up 1% against the dollar and 0.8% against the pound.
Bank stocks, which benefit from rising rates rose 0.9%, outperforming the broader stock market which fell 1.8%.
GRAPHIC - German 10s/30s yield curve
https://fingfx.thomsonreuters.com/gfx/mkt/gkvlgjlnlpb/german%20yield%20curve%20feb%203.png