European Central Bank: Hawkish hike – and weaker bonds

The ECB’s hawkish 25-basis-point hike and higher medium-term inflation risks point to further tightening and renewed pressure on European sovereign bonds.

• The ECB raised its deposit rate to 2.5% unanimously, citing Middle East conflict-related energy inflation and warning that inflation would remain well above target for an extended period.
• Its 2028 forecasts increased to 2.1% for headline inflation and 2.3% for core inflation, from 2.0% and 2.2% respectively in June; these projections already assume two additional ECB hikes.
• Staff raised GDP growth forecasts because of greater-than-expected euro-area resilience, while oil at about $105 per barrel and gas at about €80 per MWh had exceeded the adverse-scenario peaks of $100 and €77.
• The ECB did not hike by 50 basis points, with Lagarde stressing that conditions could change “almost overnight”; weaker food-price inflation also led the bank to leave its 2026 inflation forecast unchanged at 3.0%.
• After the meeting, European short-end yields rose by as much as 20 basis points and curves flattened; market pricing later shifted to three further hikes by April 2027, taking rates to 3.25%, with positioning-related forced selling contributing to the move.

Takeaway: The authors see the risks skewed toward another ECB hike this year and acknowledge near-term volatility, but Gareth Hill still considers sovereign bonds attractively priced and believes an overweight duration is sensible, focused on the best medium-term value.