By Dhara Ranasinghe
LONDON (Reuters) - Germany's borrowing costs rose to their highest level in over two months on Wednesday, and were set to end August with their biggest monthly surge in over 30 years, as data showed inflation in the euro area hitting another record high.
Bond markets across Europe have been battered this month as surging gas prices, fueled by Russian supply concerns, exacerbated inflation fears and pushed up expectations for higher interest rates even as recession fears grow.
Euro zone inflation rose to another record high at 9.1% this month, beating expectations and solidifying the case for further big European Central Bank rate hikes.
Significantly, closely-watched underlying price growth, which filters out volatile food and energy prices, jumped to 5.5% from 5.1%.
"The most disappointing aspect of the inflation data is the core measure, where we have a bigger increase than in the headline measure," said Chris Scicluna, head of economic research at Daiwa Capital Markets.
"Even though we will get more support measures to help ease the gas crisis, inflation will move higher unless policymakers can get a better grip on gas markets in the euro area."
In a sign of the scale of the unease, bond markets were set to end August with heavy price losses that have sent yields soaring.
In Germany, the euro zone's benchmark bond issuer, two-year yields rose to their highest since mid-June at 1.238% and were up 5 basis points (bps) on the day by 1506 GMT.
They are up just over 90 bps for the month, set for its biggest monthly rise since 1981, according to Refinitiv data.
(Graphic: German 2-year bond yield set for biggest monthly jump since 80s, https://fingfx.thomsonreuters.com/gfx/mkt/znpnewdbkvl/DE3108.png)
Germany's 10-year bond yield was poised for its biggest monthly jump since 1990, up over 70 bps. It rose to its highest in just over two months at 1.584%.
French and Dutch, and outside the euro zone, British bond yields were also set for their biggest monthly jumps in decades.
While gas prices have come off their peaks, they are still up 30% in August alone.
Russia halted gas supplies via a major pipeline to Europe on Wednesday, intensifying an economic battle between Moscow and Brussels and raising the prospects of recession and energy rationing.
"Front-end rates are very much dancing to the energy market's tune and this is what propelled them higher in August," said ING senior rates strategist Antoine Bouvet.
"The ECB, by voicing fear of de-anchoring of inflation expectations, has effectively encouraged greater correlation between bonds and energy," he said.
Money markets are pricing in over a 50% chance the ECB will hike rates by 75 bps when it meets next week, with bets rising sharply following a Reuters report on Friday that policymakers would discuss a 75 bps move, followed by hawkish commentary at the Jackson Hole symposium.
On Wednesday, Goldman Sachs also revised its call to a 75 bps hike.
With inflation-linked bond yields rising faster than conventional yields on Wednesday, a long-term market gauge of euro zone inflation expectations fell to its lowest in two weeks at 2.08%.
(Graphic: Euro zone inflation vs. long-term market expectations, https://graphics.reuters.com/EUROZONE-MARKETS/ECB/egvbkrnoepq/chart.png)
(Reporting by Dhara Ranasinghe, additional reporting by Yoruk Bahceli; Editing by Ana Nicolaci da Costa, Tomasz Janowski and Jonathan Oatis)