Market volatility followed the Fed's decision to keep interest rates unchanged, while signaling that the tightening cycle is far from over.
Euro zone government bond yields broke a multi-day decline on Thursday, but remained separated from rising U.S. Treasury yields as the Federal Reserve's hawkish pause in raising rates clashed with the U.S.-Iran peace agreement.
The yield on Germany's benchmark 10-year Bund, which is a benchmark for Europe, rose to 2.92%. At the same time, the yield on policy-sensitive two-year notes, which moves in tandem with the European Central Bank's short-term interest rate forecasts, approached a weekly high of 2.61%.
Market volatility followed the Federal Reserve's decision to keep interest rates unchanged, while signaling that the tightening cycle is far from complete. Swap markets quickly recalculated their expectations after the news, raising the implied probability of a December rate hike to 85%, a sharp jump from the 42% implied in prices just before the central bank meeting.
This led to a sharp increase in borrowing costs in the United States on Wednesday. The yield on the policy-sensitive U.S. two-year notes jumped to the highest level in more than a year at 4.166%, while the yield on the benchmark 10-year Treasury bonds rose to 4.43%.
At the same time, the U.S. and Iran signed a temporary peace agreement, with both countries releasing the text of the agreement, which further pushed up oil prices, providing a tailwind for the eurozone, which is heavily reliant on energy imports.
Although the prospect of higher U.S. interest rates for longer has led to a sharp rise in Treasury yields, the reaction across the Atlantic has revealed a divide in how bond markets view economic prospects.
This striking divergence highlights the economic disconnect between the rapidly growing U.S. economy and the more fragile recovery in Europe.
The decline in oil prices, driven by the potential return of Iranian oil, is acting as a double-edged catalyst. It does not interfere with the aggressive stance of the Fed, but it provides a welcome disinflationary boost to the European economy, which has recently shown signs of overheating.
At least four representatives of the European Central Bank, including Chief Economist Philip Lane, are expected to speak later today, and markets will be closely monitoring any hints about the future trajectory of the bloc's interest rates.
The Bank of England is expected to maintain interest rates
However, the yields on two-year and 10-year British bonds remained at their mid-April lows of 4.188%.
It is widely expected that the Bank of England will keep interest rates unchanged. Instead, the real market catalyst of the day will likely be the forecast by Governor Andrew Bailey, with traders analyzing every word for clues about the UK's own trajectory for the final rate.