Market pricing suggests two interest rate hikes by the ECB and Bank of England this year! German bond yields hit a 15-year high, UK bond yields approach an 18-year peak.

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German government bond yields have reached their highest level since 2011, putting pressure on the global bond market. Meanwhile, although the European Central Bank (ECB) has stood pat, the market has already begun to price in rate hikes this year.

Brent crude oil prices broke above $100 per barrel during ECB President Lagarde's press conference, fueling inflation expectations. The 10-year German Bund yield rose as much as 4 basis points in a single day to 3.21%, and traders have fully priced in two ECB rate hikes this year.

The UK bond market has also been dragged down by the recent surge in oil prices, with the 10-year gilt yield at 5.09%, nearing the 18-year high set in May. Traders now bet that the Bank of England will raise rates twice to 4.25% by year-end, and hike again to 4.5% by mid-next year.

Lagarde said there are currently no signs of a "second-round effect" of inflation, but clearly left room for a rate hike in September. This statement reinforced market uncertainty about the ECB's policy path and further depressed European bond prices.

The energy supply shock caused by the ongoing escalation of the Middle East situation is pushing up government bond yields worldwide. Europe’s heavy reliance on oil and gas imports and the sharp fluctuation in energy prices have made the inflation outlook in the eurozone more complex, putting pressure on both the bond and stock markets.

ECB "pause" is not the end

This time, the ECB kept its benchmark interest rate unchanged at 2.25%, but the market has interpreted this pause as retaining policy flexibility, rather than the end of the tightening cycle.

Madison Faller, global investment strategist at J.P. Morgan, said: "The most appropriate understanding of today's ECB pause is that the foot is hovering above the brake pedal. Leaving options open should not be misinterpreted as complacency."

In Germany, defense and infrastructure investment plans worth hundreds of billions of euros are being accelerated, and large-scale bond issuance continues to support the uptrend in yields.

Some analysts believe that if such expenditures accelerate growth in Germany and neighboring economies, it will further reinforce the ECB’s need to tighten policy.

Has the bond market sell-off become excessive?

Despite the continued rise in yields, some investors are beginning to believe that the correction in the European bond market has exceeded what fundamentals justify.

Ed Hutchings, Head of Fixed Income at Aviva Investors, said: "Value is starting to emerge in European bonds, and building up positions is becoming attractive, though some caution is still needed in the short term."

Niall Scanlon, portfolio manager at Mediolanum, says the sharp rise in energy prices has disrupted his original strategy. "We were overweight at the front end based on ECB expectations, which clearly hasn’t worked," he said. "Oil and gas prices have shifted significantly, and we must respect these moves."

Scanlon also pointed out that the market is overestimating the extent of ECB rate hikes being priced in.

Correlation between oil prices and interest rates becomes prominent again

Bloomberg macro strategist Skylar Montgomery Koning pointed out that interest rates in Europe and the UK have basically returned to trading patterns linked to oil prices.

She emphasized that front-end yields are relatively sticky when oil prices retreat, with price volatility smaller than during May's rally. But if oil prices continue to rise, the signal from the correlation is clear—rising crude will again become a common headwind for both bond and stock markets.

The US market is also not immune. Long-dated Treasuries have stayed above 5% for more than a week, the longest streak since 2007, and the Federal Reserve will hold its rate decision meeting next week.

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