Quarterly Outlook
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John J. Hardy
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ECB preview: European sovereign bond yields are likely to remain rangebound until the first rate cut.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The European Central Bank (ECB) is unlikely to push against markets' expectations of a rate cut in June. This, coupled with a downward revision of the staff macroeconomic projections in inflation and growth for this year, gives European sovereigns room to gain across maturities. Even in the most hawkish scenario, where the forecasts show inflation to stay well above 2% for the rest of the year, the German yield curve doesn't have much space to bear-flatten considerably as rate cuts will still be expected in the near future due to the ongoing disinflationary progress. It is, therefore, compelling to extend one portfolio's duration up to the ten-year tenor. However, investors may need to wait a little bit longer for a bond bull rally. Indeed, the waning down of the Pandemic Purchase Program (PEPP) will start in June, and a new monetary policy framework will be announced in the spring. That's why we expect sovereign bond yields to trade rangebound until the rate-cutting cycle begins.
ECB macroeconomic projections: inflation and growth to be revised downward.
Although the three-month and six-month annualized headline and core CPI rates suggest that price pressures in Europe are below the ECB target, they are also showing signs of bottoming.
Recent monthly inflation data, have been lower than expected, leading to a probable revision of the ECB's inflation staff projections for 2024. The question is, to what extent?
Market expectations are for headline inflation to drop to 2.3% this year, while core inflation is expected to remain around 2.5%. That's much lower than the 2.7% for core and headline CPI showed by the ECB staff projections in December 2023.
GDP forecasts are also crucial since preliminary data show weaker growth than expected by the latest ECB staff projections.
Three possible ECB meeting outcomes:
1. Dovish scenario (bullish for bonds). The ECB's macroeconomic projections align with market expectations. As a result, the probability of a rate cut in April will increase, triggering a bull-steepening of the yield curve. This will benefit all maturities across the yield curve.
2. Base scenario (bullish for bonds). The new staff forecasts show headline inflation close to target in 2024 but they will not revise 2025 inflation downwards. In such a scenario, the German yield curve is also likely to bull-steepen. However, long-term rates will remain somewhat supported as the projections indicate that the central bank will need to be cautious about cutting rates too aggressively.
3. Hawkish scenario (bearish for bonds). The projections show inflation to remain well above target throughout 2024, with Lagarde ruling out an April cut. In this case, the yield curve is likely to bear-flatten slightly, but not significantly, because the ECB will confirm its intention to begin cutting rates in a few months.
It's important to remember that in any of the situations mentioned above, the European Central Bank (ECB) will still be preparing to gradually reduce its Pandemic Purchase Program (PEPP) starting from June. Additionally, the ECB will make a decision on a new monetary policy framework in the coming weeks. Consequently, European sovereigns will likely continue trading rangebound until the first interest rate cut occurs. Hence, any bond gain next week may wane in the following weeks.
Other recent Fixed Income articles:
27-Feb Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.23-Feb Two-year US Treasury notes offer an appealing entry point.
21-Feb Four reasons why the ECB keeps calm and cuts later.
14 Feb Higher CPI shows that rates volatility will remain elevated.
12 Feb Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.
06 Feb Technical Update - US 10-year Treasury yields resuming uptrend? US Treasury and Euro Bund futures testing key supports
05 Feb The upcoming 30-year US Treasury auction might rattle markets
30 Jan BOE preview: BoE hold unlikely to last as inflation plummets
29 Jan FOMC preview: the Fed might be on hold, but easing is inevitable.
26 Jan The ECB holds rates: is the bond rally sustainable?
18 Jan The most infamous bond trade: the Austria century bond.
16 Jan European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.
10 Jan US Treasuries: where do we go from here?
09 Jan Quarterly Outlook: bonds on everybody’s lips.
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