Irish government bonds were caught up in an international sell-off yesterday, sparked by signs that central banks may increase interest rates more quickly than had been expected to fight inflation. This is likely to signal an increase in the cost of borrowing for the State this year, even though borrowing rates remain low by historical standards.
As bond prices fell on Thursday, the interest rate on 10-year Irish government bonds rose to 0.65 per cent, compared with 0.52 per cent at the previous close and their highest yield in three years. This was in line with other international markets as bond markets reacted to a 0.25 per cent interest rate increase from the Bank of England and a change in tone from the ECB president Christine Lagarde. She went further than previously in recognising the inflationary risks and refused to rule out an ECB interest rate increase this year.
The ECB had previously indicated that it was not expecting to have to increase its key interest rates this year, as it thought inflationary pressures would moderate. Lagarde said yesterday that the bank still expected price pressures to ease later this year, but that the risks were now to the “upside” and the bank was ready to use all its policy instruments if and when necessary. Markets are now pricing in an increase in the rate it pays banks for overnight deposits, currently minus 0.5 per cent, to about minus 0.1 per cent by the end of the year.
ECB bond purchases
While bond market interest rates remain low in nominal terms across the EU, investors are becoming unsettled about signs of inflation remaining high for longer than anticipated and a faster pace of increase in short-term interest rates. Also, the ECB is due to stop additional purchases of bonds under its pandemic support programme at the end of March, removing a support for the market. As a result, bonds have weakened since the start of the year and the interest rates on the Irish 10-year bond has risen from about 0.25 per cent at the start of January to over 0.65 per cent. The yield on Italian 10-year bonds, which may become a market focus, rose 0.23 percentage points on Thursday to 1.64 per cent.
Investors are now starting to worry that the ECB may have been behind the curve in fighting inflation, with the Bank of England already increasing interest rates twice and the US Federal Reserve Board likely to announce four or five small rises during the year. Market sources in Dublin noted that US 10-year bond rates are now 1.82 per cent and that on this basis European bond rates may be set for steady rises, if signs of inflation remain.
While borrowing costs for the Irish Government may remain low, the ability to launch long-term borrowings at rates close to zero per cent now look to be over and with special ECB support for the market starting to be withdrawn, investors will again start to focus on the budget position of each individual State.
