Euro zone bond yields rise as German business sentiment hits 2.5-year peak

The bond markets were catching their breath on Thursday after a week of turbulence, and the news coming out of Germany was giving them reason to settle into a new rhythm. German companies were feeling better about themselves than they had in two and a half years. The Ifo institute, which tracks business sentiment across Europe's largest economy, reported that its climate index had climbed to levels not seen since November 2018, driven by a surge of optimism about the second half of the year ahead.

This brightening outlook was pushing borrowing costs higher across the eurozone. Germany's benchmark 10-year government bond yield—the Bund—rose to minus 0.17 percent, a single basis point gain on the day but part of a larger climb of around twelve basis points since the European Central Bank had reaffirmed its commitment to easy monetary policy just two weeks earlier. The economic data was pointing in one direction: recovery. And recovery, in the eyes of bond traders, meant that the massive stimulus programs central banks had deployed to cushion the pandemic's blow might not be needed forever.

The signal was reinforced by a broader measure of economic health. IHS Markit's Flash Composite Purchasing Managers' Index, which synthesizes activity across manufacturing and services, had jumped to 59.2 in June—its highest reading since June 2006. That kind of momentum suggested the eurozone was not merely bouncing back but accelerating. Analysts expected this strengthening to keep upward pressure on borrowing costs as investors repositioned themselves for a world where central banks might tighten policy sooner rather than later.

The shift had been turbulent. The U.S. Federal Reserve had signaled a more hawkish stance the previous week, sending shocks through global markets. But by Thursday, according to Christoph Rieger, head of rates and credit research at Commerzbank, the bond markets had found their footing again. "Bond markets appear to have found a new balance after the Fed-induced volatility eruption last week," he said. The long end of the yield curve had re-steepened, and inflation expectations had widened again, suggesting that fundamental economic conditions were reasserting themselves over the noise of positioning and panic.

Inflation expectations, in particular, were climbing. The five-year, five-year breakeven inflation forward—a market gauge of what traders expected inflation to average over a five-year period beginning five years from now—had risen to almost 1.58 percent, up sharply from two-month lows hit just days before. This was the market's way of saying that sustained economic growth might eventually push prices higher, and that central banks would have to respond.

There was more to come. A Bank of England policy decision scheduled for later that Thursday could add further upward pressure on yields if officials suggested that the massive stimulus programs deployed during the pandemic could be withdrawn sooner than markets had anticipated. The question hanging over all of this was whether the recovery was real and durable, or whether it was a temporary bounce that would fade once the reopening effects wore off.

Meanwhile, Italy was taking advantage of the improving sentiment to extend its debt maturity. The country began marketing a new floating-rate bond maturing in April 2029, longer than its usual offerings, a move analysts at UniCredit interpreted as an effort to lock in favorable borrowing conditions while the market was receptive. Italy's 10-year yield rose just half a basis point to 0.90 percent, suggesting investors still saw the country's debt as manageable in this environment.