By Paul J. Davies 

European government bonds sold off sharply in recent days, with yields following U.S. Treasurys higher and German borrowing costs hitting their loftiest levels in two years.

Expectations for rising inflation in Europe remain far behind those in the U.S., but they are rising after a jump in producer prices this month. A pickup in vaccination rates is also boosting hopes about a reopening of the region's economies, according to investors and analysts.

German 10-year yields rose to minus 0.097% on Thursday, up from minus 0.122% on Wednesday and the first time they have been higher than minus 0.1% since May 2019, according to Tradeweb.

German government bonds are now the only negative yielding 10-year government bonds in the eurozone after Dutch yields moved into positive territory on Wednesday.

The rise in European yields this week has been swift, leaving investors caught out by being too comfortable in their view that yields wouldn't move, especially among southern European countries, according to Alberto Gallo, global head of credit strategies at fund manager Algebris.

"We're not going to see a major selloff, but we are in an environment where bond yields are not attractive, inflation is starting to pick up and investor positioning is complacent," he said.

European inflation expectations as measured by the difference between 10-year German bond yields and so-called real yields on inflation-protected bonds were 1.54% on Thursday, according to Tradeweb, near the highest level for years. U.S. inflation expectations have risen much faster and higher. The 10-year so-called break-even rate hit 2.56% on Thursday.

Ralf Preusser, rates strategist at Bank of America, said that while there had been some positive data on Europe's economic outlook and some extra supply of longer-dated German bonds, those things probably weren't the main drivers of the move in yields. He said European yields were being dragged higher by the moves in U.S. yields.

"European break-evens have repriced in line with the U.S., which does suggest the U.S. inflation story plays a role," he said.

The European Commission, the European Union's executive arm, upgraded its forecast for eurozone economic growth in 2021 on Wednesday to 4.3% from 3.8% at its last forecast in February.

Despite the increase in yields into positive territory for many eurozone countries, they remain near historic lows.

Rising yields appear to be driven more by stronger growth expectations, rather than worry about the European Central Bank pulling back stimulus. As evidence, the closely watched difference between Italian and German 10-year yields, a barometer for financial stress in the region, remains at just 1.12 percentage points, close to the recent multiyear low.

Eventually, rising inflation would lead the ECB to slow its bond purchases and even to lift interest rates from negative territory. One guide to investor expectations for higher rates in the future is the difference between short-term yields and longer-term yields. For German debt the spread of 10-year bond yields over two-year yields has risen to its highest level since May 2019, shortly before fears of a global slowdown led to a collapse in bond yields across the U.S. and Europe.

The ECB's next monetary policy meeting in June is expected to see debate about whether the central bank should slow its bond purchases as growth rebounds. Any pullback in stimulus could push yields in southern Europe's more vulnerable economies, such as Italy, Spain and Portugal, higher.

Mr. Gallo said he thought Italian yields were currently a bit too close to German yields, leaving them vulnerable to further rises. However, the ECB should try to keep funding costs low for Italy, he added.

Write to Paul J. Davies at paul.davies@wsj.com

 

(END) Dow Jones Newswires

May 13, 2021 09:38 ET (13:38 GMT)

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