Traders Bet ECB Will Pause Hikes Amid French Bond Selloff

Traders are betting that the European Central Bank (ECB) will pause rate hikes due to financial stress, particularly a selloff in French bonds. This wager mirrors failed predictions in 2022 and 2023 when the ECB continued raising rates despite market turmoil, as inflation remained above its 2% target. Euro-area inflation stood at 3.8% in September, while the ECB's deposit rate is currently 2.50%. The recent stress caused Germany's two-year bond yield to drop from a peak of 3.32% on September 28 to 3.02%.

The gap between French and German 10-year borrowing costs widened to 1.54 percentage points on October 2, the broadest since 2011. This selloff also affected bonds from Italy, Belgium, and Greece, leading Spain to call a snap election. France's 2027 budget deficit target of 5% is still above the EU's 3% cap, contributing to the market's assumption that the ECB may ease off on rate hikes.

Money-market pricing indicates that traders have reduced their expectations for ECB rate hikes. On October 5, they priced in just 0.28 of a hike for the October 29 meeting, down from nearly one full hike in mid-September. ECB President Christine Lagarde and Chief Economist Philip Lane have suggested that higher long-term rates could slow growth and amplify energy costs, reinforcing the traders' bets.

Historical data shows that similar financial stress in 2022 and 2023 led to temporary repricing but ultimately did not deter the ECB from raising rates. Core inflation was a key factor, remaining elevated despite market turbulence. The ECB's tools, such as the Transmission Protection Instrument (TPI), aimed to stabilize borrowing costs without compromising its inflation mandate. The current scenario differs from 2011, when the ECB cut rates amid a debt crisis, as Italy and Spain's borrowing costs are now significantly lower.