Euro yields linger at 1-month lows as sinking oil calms inflation jitters

Eurozone government bond yields traded flat on Tuesday, with benchmark German borrowing costs hovering near their lowest levels in over a month and a half, as a sustained collapse in global crude oil prices provided fixed-income desks with a powerful disinflationary buffer ahead of a critical U.S. inflation report. 

The benchmark German 10-year Bund yield was largely unchanged at 3.253%, consolidating after dropping on Monday to its lowest point in more than six weeks. At the front end of the curve, the policy-sensitive two-year German yield was also flat on the day, holding steady at 2.979% as traders opted to keep their powder dry.

Crude futures fell another 1% on Tuesday to $91.56 a barrel, plunging to their lowest levels since early September and settling comfortably below the psychological $100 threshold.

The energy sell-off has accelerated as investors pin their hopes on potential diplomatic talks between the United States and Iran, which has significantly dialed back the immediate threat of a wider conflict in the Persian Gulf.

For European bond traders, the cheapening of fuel inputs is a game-changer. Throughout October, surging oil prices had threatened to compress corporate margins and unanchor consumer inflation expectations, putting pressure on the European Central Bank to maintain restrictive borrowing costs even as the regional economy stalled.

With oil retreating, that acute stagflationary tax is rapidly dissolving, giving duration buyers the confidence to hold yields near their recent autumn troughs.

Paralyzed by U.S. CPI and rising Fed hike bets

Despite the fundamental relief emanating from the energy sector, European bond traders refused to aggressively extend the rally on Tuesday, effectively paralyzed by the looming release of the U.S. Consumer Price Index (CPI) later in the session.

Transatlantic yield correlations mean that European paper remains highly vulnerable to American economic surprises. Economists anticipate the October U.S. CPI report will show prices increasing at a moderate pace, but remaining stubbornly elevated enough to force the Federal Reserve into taking further action.

Following a blowout U.S. October jobs report last Friday, fixed-income markets have violently repriced the Fed’s terminal rate path. Traders are now pricing in an 84% probability of a U.S. rate hike next month, a sharp increase from 74% just a week earlier, according to the CME FedWatch tool.

A hotter-than-expected inflation print would likely cement those hawkish Fed expectations, exerting intense upward pressure on U.S. Treasuries that would inevitably drag European borrowing costs higher in sympathy.

Until the U.S. inflation data clarifies the transatlantic interest-rate spread, Eurozone bond desks appear content to ride out the session in a narrow, defensive holding pattern.