Euro-zone government bond yields remained steady on Tuesday after a de-escalation in tensions between Israel and Iran reduced near-term market anxiety about a widening Middle East conflict and potential disruption to oil shipments.
Iran and Israel said on Monday that they would end military operations following an appeal from U.S. President Donald Trump, who is seeking a peace agreement aimed at reopening oil flows through the Strait of Hormuz. A reopening of the Strait could relieve concerns about energy supplies and, in turn, lower expectations for further monetary tightening by major central banks.
Germany’s 10-year yield, the benchmark for the euro area, was last at 3.051%, effectively unchanged on the day.
All eyes are now on the European Central Bank’s (ECB) policy announcement on Thursday. The ECB is widely expected to raise its key deposit rate by 25 basis points to 2.25% - its first change in rates in a year. Beyond this move, the main market question is what the bank will do next.
There is a clear case for retaining a hawkish bias after such a hike, said Gavekal Research economists Cedric Gemehl and August Gudmundsson in a note.
With a single price stability mandate, the ECB’s instinctive response to a shock that has pushed realized and expected inflation above its 2% target will be to lean hawkish to preserve its inflation-fighting credibility, regardless of the nature of the shock.
Money market futures are pricing in 68 basis points of tightening by the end of the year, which implies one additional quarter-point hike and a greater than 70% chance of a third hike.
Germany’s two-year bond yield, which is particularly sensitive to shifts in ECB rate expectations, fell 2.5 basis points to 2.677% on Tuesday after reaching an almost three-week high of 2.734% on Monday.
Investors are balancing the immediate easing of geopolitical risk against the prospect of a renewed tightening cycle by the ECB. The interaction between energy-supply developments and monetary policy expectations remains central to moves in sovereign yields.
Market participants will closely monitor the ECB statement and accompanying guidance on Thursday for signals about the persistence of a hawkish stance and the likely path of rates through the rest of the year.