By Yoruk Bahceli and Dhara Ranasinghe

(Reuters] – Euro zone sovereign bond yields soared while the euro dropped on Thursday following a surprising announcement from the European Central Bank about ending its bond buying program in the third quarter.

Italy’s bond yields, a major beneficiary of the ECB’s bond buying stimulus surged by more than 20 basis points, while German bond yields rose to three-week highs, surpassing unwinding losses since Russia’s invasion of Ukraine in February 24th.

Initial growth in Europe’s single currency was good, however, it proved to be short-lived and the stock market remained in deep red.

It was a shock as investors didn’t expect any major announcements in light of the uncertainties created by war in Ukraine.

According to the ECB, purchases made under the traditional Asset Purchase Programme (APP) during the third-quarter would not be as large as previously anticipated and could end within the third quarter depending upon economic data.

The bank has increased its inflation projections but reduced its outlook for growth due to rising commodity prices.

The ECB stated that changes in interest rates would take place after the bond purchase ends and will be gradual.

Germany’s 2-year yield was more sensitive than expected to interest rate expectations and rose by 17 bps to –0.35%, as traders increased bets on ECB rates hikes.

Germany’s five year bond yield was positive for first time since Feb 28th. The 10-year yield rose to 0.30% from 10bps.

Markets in Euro zone money moved to value in 45 bps ECB rises by December versus 35 bps after the ECB’s decision. They also placed forward bets of a 10 basis-point increase to July compared with September prior to that decision.

“The fact tapering is progressing apace is a signal that the bar for the ECB is high to put normalisation off,” stated Antoine Bouvet. Senior rates strategist at ING added that ECB projections were consistent with the bank raising its policy rate from -0.50% to 0% next fiscal year.

SELLOFF

Italy had the best two-year yields, which were at 0.199% last week. They were 21 bps higher than they were before. On Thursday, they were as low as-0.05%.

From around 150 bps in the prior meeting, the closely monitored gap between German 10 year yields and Italian yields rose to 162 bps.

Bouvet declared that “Rates are wrong to jump” and that the rate increase was primarily in the peripheral areas, where there has been a widening of tightening since then. He said this because the delayed normalization by the ECB had been delayed.

“This assumption has been proven wrong, we’re back on a widening path.”

After the decision was made, a key indicator that measures long-term inflation expectations in the euro area dropped dramatically to 2.05 % from 2.16% on Thursday.

“The ECB has chosen to overlook some of the uncertainties created by the war. Marchel Alexiovich, European economist, Saltmarsh Economics said that the immediate impact on inflation will be greater. We may see inflation rise to 6%. This would increase inflation expectations.

Although the euro gained more than 50% after the ECB’s statement, it fell back. Last time it was down 0.5% at $1.10.

After the ECB announcement, euro zone stock fell to session lows of 1.7%. A gauge of bloc’s bank stocks was 2.25% below.