After rising by 300bp last year it has been widely assumed that European rates should begin to fall by the end of this year.
But the path to lower inflation, on which this view is predicated, is likely to be volatile and that suggests there is plenty of scope for disruption.
After the benign US inflation prints of November and December, the rates market received a rude jolt this week following US core January inflation data, which rose by a higher-than-expected year-on-year rate of 5.6%.
Coupled with a US unemployment rate of 3.4%, the lowest since 1969, the Federal Reserve may need to raise rates by more than the two quarter point increases that many people had, until this week, assumed.
Driving the point home on Tuesday, the Fed’s chair, Jerome Powell, reiterated his view that taming inflation would “take quite a bit of time” and was unlikely to come down “painlessly”.
As with the US, European core inflation of 5.2% was at a record high in January. Moreover, just like the US, the European labour market is tight.
Wage growth over the next few quarters is “expected to be very strong compared with historical patterns,” according to ECB research from January.
So, while the ECB doves are calling for moderation, the hawks are likely have the data on their side, putting them in the ascendency.
This effectively means that at some point financial markets are likely to be put on the back foot, a process that may have already begun.
In sympathy with the sell-off in US Treasuries, German 10 year yields soared by almost 30bp from last week’s low to finish on a high at 2.47% on Thursday.
But the fact that European stocks were trading close to their record highs and the iTraxx Senior Financials index was trading 70bp inside last year’s widest levels at 84bp on Thursday, showed just how far out of line equity and credit markets may have become.
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