Euro Zone Long-term Inflation Expectations Below 2%, Yields Tumble

Euro zone bond yields fell sharply on Monday while long-term inflation expectations dropped below 2% as recession fears deepened after warnings about a possible cut in Russian gas supplies.

French Finance Minister Bruno Le Maire said on Sunday the French government was preparing for a total cut-off of Russian gas supplies.

Germany has moved to stage two of a three-tier emergency gas plan, warning of recession if Russian gas flows are halted.

The five-year, five-year forward inflation swap, hit its lowest since March 2 at 1.9898%, below the 2% target of the European Central Bank.

U.S. Treasuries borrowing costs provided further downside pressure on euro area yields, with the 10-year falling 12 bps to 2.976%.

Analysts still expect a quite aggressive monetary tightening path by year-end, while being more cautious over 2023.

"In a nutshell, faster (monetary) tightening (in 2022) and then a stop next year, if not even a reversal," said Erik F. Nielsen, group chief economics adviser at Unicredit.

Nielsen mentioned the chance of the global economy falling into recession in 2023 and inflation rates coming off their peaks and starting to decline probably quite quickly.

"I'll bet my money on the European Central Bank (ECB) ending its hikes well before we get to policy rates of 2%," he added.

Money markets price in around 145 bps of ECB rate hikes by year-end, and around 195 bps by December 2023.

INFLATION DATA

Germany's 10-year government bond yield, the euro zone benchmark, fell 11.5 bps to 1.23%. It hit a five-week low at 1.072% last week.

Investors await the U.S. inflation data on Wednesday, which could force another super-sized hike in rates.

Commerzbank analysts noted that front-loaded Fed tightening was also spilling over to euro short-term rate (ESTR) forwards.

Graphic: ESTRforward-

"A crucial litmus test for the tightening pattern could come much earlier, though, with the planned end of the Nord Stream 1 maintenance targeted to end one day after the ECB lift-off decision," the Commerzbank analysts said in a research note.

Germany is in the dark about how much gas Russia will pump through the Nord Stream 1 pipeline after the end of a 10-day maintenance shutdown that started on Monday, Germany's energy regulator told Reuters.

Italy's 10-year government bond yields fell 10 bps to 3.27%, with the spread between Italian and German 10-year yields widening to 204 bps.

Investors expect the spread to remain around 200 bps before the announcement of the ECB's so-called anti-fragmentation tool expected at its next policy meeting.

ECB policymakers pledged to buy more bonds from debt-laden countries such as Italy to contain a widening spread between their borrowing costs and Germany's that might hamper monetary policy transmission across the bloc.

Bundesbank chief Joachim Nagel disagreed with that decision and warned against trying to decide the right market spread as that was "virtually impossible" and risked making governments complacent, according to sources at the meeting. ECB aid to tackle rising government debt yields in some euro zone countries should come with conditions, an adviser to German Finance Minister Christian Lindner said.