Eurozone inflation surprised to the upside for the seventh consecutive month in January, rising to a record 5.1%, far above the central bank’s 2% target.

The unexpected data seems to have finally persuaded European Central Bank (ECB) president Christine Lagarde to ditch her ‘transitory’ inflation narrative which brings the bank into line with the Bank of England and US Federal Reserve.

Both the UK and US central banks have signaled their willingness to hike interest rates more aggressively to deal with stickier than expected inflation with the Bank of England pushing through back-to-back increases.

The direction of travel for UK rates seems clear given that four of the nine Bank committee members wanted to push through a 0.5% hike instead of 0.25%.

While Lagarde highlighted key differences between the eurozone and the economies of the UK and the US, which has seen a bigger jump in consumer demand, Lagarde didn’t dismiss the idea of raising rates later this year and said the risks were tilted to the upside.

The U-turn opens the door to rate rises, possibly before the end of the year, with bond markets quickly pricing in the possibility by pushing bonds yields higher. 

According to Bloomberg data, markets are pricing in a zero-deposit rate by the end of 2022 compared with the current rate of minus 0.5%.

In recent weeks the benchmark 10-year German bund yield has been nudging into positive territory for the first time since the start of the pandemic and today it stands at 0.25%. The hawkish tone gave a boost to the euro which has rallied by 1% against the US dollar.

The hawkish pivot by the ECB had an immediate and unwelcome impact on Europe’s peripheral debt markets which saw increased selling. This has pushed up Italian 10-year government bond yields sharply in recent days from 1.45% to almost 1.84%.

The implied spread between German and Italian 10-year yields has widened to 1.6% for the first time since the Autumn of 2020 reflecting increased fear over the Europe’s most indebted members. A year ago, the equivalent spread was 0.9%.

Italy is Europe’s third largest economy and one of the most indebted with government debt equivalent to 155% of gross national product in 2020 up from 135% before the pandemic.

If the ECB does move on rate increases, they are expected to happen towards the end of 2022, some time after the central bank ends its asset purchase programme in June.

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