By Stefano Rebaudo
(Reuters) -German government bond yields hit a one-week high on Tuesday after falling earlier in the session as investors’ focus shifted to monetary policy tightening expectations from concerns about the escalating crisis over Ukraine.
Euro zone money markets priced in a 10 basis point (bps) rate hike in July and an 85% chance of rate hikes worth 50 bps by year-end. [IRPR]
Until last week and following the ECB's Feb. 3 meeting, money markets were fully pricing in a 10 bps rate hike by June and 50 bps worth of hikes by December.
Germany's 10-year government bond yield rose 7.5 bps to a one-week high at 0.28%, after falling as low as 0.146%, its lowest level since February 4.
The 2-year and the 5-year borrowing costs jumped about 8.5 bps.
Russia faced the prospect of new Western sanctions after President Vladimir Putin recognised two regions in eastern Ukraine as independent and ordered the deployment of troops there, deepening fears of a major war in Europe.
German business morale improved in February, despite the Ukraine crisis, as businesses hope for an end to the coronavirus crisis, slightly boosting yields.
"Ukraine is a big deal with euro zone yields, but the ECB matters more," said Andreas Billmeier, European economist at Western Asset, part of Franklin Templeton.
"If you translate that (a possible conflict in Ukraine) into policy reaction, it would probably mean more fiscal support of some sort, while it’s not a clear cut driver for the ECB and European yields," he added.
But some investors expect central banks to delay their exit plans from pandemic monetary stimulus until a diplomatic solution of tensions over Ukraine is in sight.
Mauro Valle, head of fixed income at Generali (MI:GASI) Investments Partners, believes money market expectations pricing in two rate hikes (of 20 bps) in 2022 "are slightly exaggerated" and forecasts that the ECB would raise rates "just once this year even if geopolitical tensions dissipate".
Some in the markets were watching moves in 5-year Russian credit default swaps (CDS) or rouble intraday.
Russia's 5-year CDS was at 310 bps.
"In early 2015, the 5y Russia CDS widened to above 600bp more than half a year after the annexation of Crimea, when the sanctions started to bite, and the Russian economy slid into recession," Commerzbank (DE:CBKG) analysts said in a research note.
The chart below shows the Bund future and the Russian CDS.
Italian government bond prices outperformed after recently underperforming. The 10-year yield rose 3.5 bps to 1.955%, while the spread between Italian and German 10-year bond yields tightened 2 bps to 167.
"Anywhere between 150 and 175 bps is where I think the (Italian-German) spread will eventually settle," UBS fixed income strategist Rohan Khanna said.
He added he didn't expect it to widen to 200-300 bps as in the past it reached those levels only during "domestic political uncertainty with the market pricing the risk of Italy restructuring its debt or potentially leaving the euro."