Strong trade-weighted EUR gives ECB green light to cut rates, but bond bull rally unlikely

Summary:

• Front-term rates are likely to drop as the ECB begins to cut rates. However, long-term sovereigns remain vulnerable to persistent inflation and an improving macroeconomic backdrop.
• The EUR is strong on a trade-weighted basis, allowing the ECB the flexibility to begin cutting rates. However, if the EUR/USD falls below 1.068, policymakers are likely to become more concerned about the currency's weakening, forcing them to be less dovish.
• As the winddown of the PEPP facility starts in July, Italian sovereign bonds will face pressure. However, investors' appetite for higher-yielding securities might offset this trend.
• We continue to favor short-term maturities up to three years, particularly 2-year Italian BTPs, which offer an appealing risk-reward ratio. The yield on these securities would need to rise above 8.8% to incur a loss, assuming a one-year holding period.

ECB policymakers have widely signaled a rate cut in June, with the swap market pricing in the likelihood of three rate cuts within the year.

To evaluate whether a bond bull rally is imminent in the euro area, it is essential to consider the following factors:

1. Eurozone economic forecasts indicate sticky inflation and an economic recovery.

The European Commission's recent economic forecasts indicate that inflation may reach its target sooner than expected, with HICP revised downward compared to winter projections. Inflation is expected to fall to 2.5% in 2024 and 2.1% in 2025. However, euro area GDP growth has been revised down by 0.1 percentage points for 2025, now forecasted at 1.4%.

This data could set the stage for a bond rally due to disinflationary pressures and a slightly slower-than-expected economy. However, it is crucial to consider the current situation: core CPI remains closer to 3% than 2%, and inflation is not forecasted to hit the target for another two years. At the same time, the eurozone economy is recovering from a real GDP growth of 0.4% in 2023 to 1.4% in 2025, therefore a recession is not in the cards. This macroeconomic backdrop is supportive for risky assets, putting at risk safe havens such as German Bunds.

2. The Euro remains strong on a trade-weighted basis.

One reason the ECB is cutting rates ahead of the Fed without concern for EUR depreciation is that the euro remains above its historical average from a trade-weighted perspective. The Euro Trade Weighted Index (TWI) considers the euro's relative strength against a basket of foreign currencies, weighted according to the Eurozone's trade volume with each respective country.

The trade-weighted index (TWI) for the euro is currently above its average since 2010. However, if the EUR/USD exchange rate dips below 1.068, the TWI will fall below this average. Despite this, policymakers are likely to view the euro's trade-weighted value as acceptable, allowing them to proceed with rate cuts.

Markets are already pricing in three rate cuts by the ECB by year-end, and the current EUR/USD exchange rate reflects these expectations. If these cuts do not materialize, or if the Federal Reserve adopts a more dovish stance than anticipated, there is the chance that the euro will strengthen against the USD.