• Euro area bonds may advance on prospect of subdued inflation
  • Oil languishes at 2008 levels, Fed in focus on Dec. 16

Euro-region sovereign bonds may weather higher U.S. interest rates next week.

While the Federal Reserve’s policy decision is the market’s main focus in coming days, it’s the fall in commodity prices and how that will weigh on the inflation outlook that might drive bonds higher in the euro area.

With crude oil prices plummeting to their lowest since 2008 on Friday, deflationary pressures will undercut the policies of the European Central Bank. A measure of the region’s future inflation expectations fell to its lowest close in almost two months, signaling that the ECB is unlikely to veer from its policy stance of monetary easing.

Benchmark German 10-year bunds climbed, with yields posting their biggest weekly decline in two months. That’s a reversal from the surge in yields seen after ECB President Mario Draghi’s deposit-rate cut and quantitative-easing boost on Dec. 3 fell short of some investors’ expectations.

“Everybody is convinced the Fed will hike rates next week but really the question is what comes after that,” said Elwin de Groot, a senior market economist at Rabobank International in Utrecht, Netherlands. Even though the ECB decision “was quite a negative surprise for the market, for now we are still in this situation where, because commodity prices are coming down, the inflation prospects have not improved. At least in the short term, that will continue to weigh on yields.”

Bund Yield

Germany’s 10-year bund yield fell 14 basis points, or 0.14 percentage point, to 0.54 percent this week as of the 5 p.m. London close on Friday. That’s the biggest drop since the week ended Oct. 2. The 1 percent security due in August 2025 rose 1.315, or 13.15 euros per 1,000-euro ($1,100) face amount, to 104.32.

Similar-maturity Italian bond yields slipped 12 basis points to 1.54 percent, while French yields fell 14 basis points to 0.86 percent. That’s a reversal from the five days ended Dec. 4, when yields on all three government securities surged more than 20 basis points.

A forward inflation swap rate that gauges consumer-price growth expectations in the euro area for a five-year period beginning five years from now fell to 1.7 percent, near its lowest close in almost two months.

Inflation Report

A report due Dec. 16 will show that the annual rate of inflation in the euro area was unchanged at 0.1 percent in November, according to the median estimate of a Bloomberg survey of economists. That is far below the ECB’s inflation target of just under 2 percent, a level not achieved since early 2013.

Oil prices have slumped to levels last seen during the global financial crisis, partly as a result of the Organization of Petroleum Exporting Countries’ strategy to defend market share against higher-cost producers. The group’s production rose to a three-year high in November, it said in a report on Dec. 10.

European bonds may also be supported by dovish rhetoric from Janet Yellen. Investors have said they expect the Fed chair to signal a gradual trajectory for future interest rate increases, even as the U.S. central bank is widely expected on Dec. 16 to move off record-low borrowing costs.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE