A year in hell for the European bond

In 2022, bonds posted their worst performance in modern financial history. German and UK 10-year yields saw their most significant annual increases as sovereign bond markets were whipped by runaway inflation and uncertainty over how policymakers would react.

In a rare event that marked a break from the era of negative interest rates and quantitative easing, eurozone implied rate volatility exceeded that of the United States. At the same time, trading costs on the main European sovereign bond markets surged. Until recently, price swings in eurozone bond markets were notoriously low due to ECB quantitative easing and sub-zero interest rates.

The lack of clarity on inflation led investors to pile into highly liquid cash-like assets, such as short-term German government bonds. Meanwhile, swap rates were boosted as demand for hedging against rising borrowing costs increased. The spread between short-term bond yields and swap rates hit a record high in September.

The ECB suspended its 0% cap on certain deposits held with eurozone central banks to prevent an influx of public liquidity into money markets. The German debt agency took steps and the ECB to increase the supply of paper available to lend in repo markets.

Historical movements in yields in the Eurozone and UK bond markets have also shocked investors. The bond volatility implied an increase in short-term trading moves, further amplifying volatility. During periods of low volatility, determining which bond is the cheapest to deliver for a given futures contract is easy and does not change. However, this year violent movements have distorted the yield curves.

The upheaval is underway. Inflation is still far from being stifled, and the ECB and the BOE are expected to raise rates further, adding to the 250 basis points and 325 basis points of tightening already achieved this year, respectively.

Meanwhile, the consequences of the protracted war in Ukraine, what it means for Europe’s energy security, and the imminent end of Covid-19 restrictions in China will add further uncertainty for the region.

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