The ECB holds rates: is the bond rally sustainable?

Following yesterday's ECB monetary meeting, we remain constructive on a bull-steepening of the German yield curve, underpinning duration throughout the first part of the year. European sovereign bonds will likely benefit from disinflationary trends, a revision of the ECB staff economic projections in March, and the beginning of the cutting cycle. Yet, long-term yields will remain volatile and could resume their rise in the second half of the year as the ECB accelerates the pace of QT and markets' rate cut expectations may not be met.

Three crucial points emerged from Lagarde’s press conference:

1. The central bank is not looking to cut rates before summer.
2. Stagnation is acceptable. The central bank is not disturbed by the marked deceleration of economic activity in the euro area. The ECB statement mentions signs of improving growth, stressing that an early rate-cutting cycle is unnecessary.
3. Wages are key. Despite some wage indicators stabilizing, Lagarde signaled that further progress in labour cost is needed to win the fight against inflation, pushing once again against expectations of early rate cuts.

While it is fair to conclude that the stance of the ECB hasn’t materially changed since the December monetary policy meeting, markets are firm in believing that interest rate cuts are likely to come early. Bond futures assign a 70% chance of a rate cut in April, followed by a rate cut at each monetary policy meeting up to roughly 150bps rate cuts by December. Such conviction led to a bull-steepening of yield curves, with 2-year German Schatz yields dropping by 8bps to 2.61% and 10-year yields dropping by 6bps to 2.28% on the day.

Is the bond rally sustainable?

To answer this question, we need to consider the following:

1. The path for steeper yield curves is set. From now on, every ECB meeting is a live meeting where there is a chance for interest rates to be cut. Therefore, yield curves can only get steeper. The question is whether yield curves will bull or bear-steepen. For the yield curve to bull-steepen, rate-cut expectations need to be met or exceeded throughout the course of the year. If cuts disappoint expectations, there is the risk for yield curves to bear-steepen. That’s why a new set of staff economic projections in March will be critical for markets to assess the central bank’s intention and forecast more accurately the upcoming cutting cycle. We expect a downward revision in inflation expectations in the March ECB staff projections, which support a broad bond rally even if a rate cut is not delivered. In the year's second quarter, the bond rally might lose steam if interest rate cuts do not keep pace with expectations, leaving duration at risk.
   
   
2. Quantitative tightening will accelerate during the second half of the year. The ECB announced in December that in the second half of the year, reinvestments under the PEPP portfolio will be tapered by €7.5bn per month and discontinued entirely at the end of the year. Because the ECB is looking to accelerate the pace of QT rather than decelerating it, it's safe to expect that the monetary policy review, which is due in spring, will lean towards a model similar to the BOE, where liquidity to banks is offered on demand, rather than relying on the central bank’s balance sheet as in the US. Therefore, lacking a deep recession, long-term yields are at risk of adjusting higher in the second part of the year.
   
   
3. A possible economic recovery in China and geopolitical tensions offer an upside risk to inflation. A rebound in price pressures would force the ECB to hold back on interest rate cuts, causing the yield curve to bear flatten.