Head of Fixed Income Strategy
Summary: Sluggish growth and faster deflationary trends during the year's first quarter are likely to put the ECB's December macroeconomic projections at odds. At the same time, the upcoming end of the TLTRO facility might call for easier financial conditions, making a March ECB rate cut likely. Such a macroeconomic backdrop calls for a bull-steepening and disinversion of yield curves, building the case to extend one’s portfolio duration. Yet, it’s unclear whether the disinflationary trend will continue during the second part of the year as geopolitical tensions rise and deflationary base effects fade. Considering that the ECB Quantitative Tightening (QT) is likely to continue despite rate cuts, markets are likely to push back on aggressive rate cut expectations, and Japanese investors might prefer their domestic markets, we remain cautious of ultra-long duration.
Markets are starting the year with a clear picture in mind: prices will fall faster than anticipated due to a marked slowdown in economic activity. Therefore, policymakers will be forced to engage in interest rate cuts earlier and more aggressively than thought.
This picture looks particularly compelling in Europe. The consensus is for inflation to undershoot ECB’s projections throughout the year and for headline CPI to hit the central bank’s inflation target by the year's third quarter. Economists at Bloomberg paint an even more dovish picture: they expect headline inflation to fall below the central bank’s inflation target by the year's second quarter due to negative energy contributions. The core measure is expected to drop below 2% soon after as prices for food and goods stagnate throughout the year.
Such deflationary trends are unlikely to be accompanied by any optimism. The eurozone has suffered a downturn, and growth is forecasted to remain sluggish throughout the year. Eurostat says the number of bankruptcy registrations in the euro area is the highest since 2015. High-interest rates and lower economic activity are unlikely to slow down such a trend, suggesting that the ECB can't remain on the sidelines for long, building the case for early rate cuts.
Contrary to market expectations, rate cuts might already start in March.
Markets give only a 30% chance that the ECB will cut rates in March because policymakers are actively pushing back against early rate cuts, and investors discard the possibility that Lagarde might cut rates without the absolute certainty that Powell will follow suit. The focus is clearly on the euro currency, which, if devalued further, might bring an upside risk to inflation.
Yet, if CPI figures in January and February drop sensibly as economic activity lags, the ECB might be forced to revise its economic projections downwards. At the same time, half of the remaining TLTRO current balance is set to expire in March, making the need for easier monetary conditions likely.
Whether the first cut comes in March or April, the bull-steepening of yield curves is set into motion, with the German yield curve likely dis-invert.
Ten-year Bund yields have recently encountered strong support at 1.9% and are on their rise to test 0.382 retracement at 2.335%. If they break above this level, they are likely to rise to 2.6%. Yet, as inflation beats on the downside, there is room for yields to test and potentially break below 1.9% to find the next support at 1.73%. If the bond rally remains underpinned by deflationary trends and the ECB cuts rates by surprise in March, yields might test and break below this level, finding support next at 0.8%.
When talking about ultra-long duration, we refer to bonds that have a maturity longer than twenty years. These instruments have a high duration and are, hence, more sensitive to changes in interest rates. While the case to extend one's portfolio's duration remains compelling throughout the first half of the year, a more cautious approach is required for buy-to-hold ultra-long fixed-income securities.
Markets are pricing for up to 150bps rate cut by the ECB by the end of the year. Although the central bank might indeed cut by more than 25bps at a time, what is also true is that a rebound of inflation during the second part of the year might stall the rate-cutting agenda. If markets were to price out part of the rate cuts for this year, that would result in higher yield across the sovereign yield curve, weighting particularly heavily on bonds with ultra-long duration.
The ECB’s balance sheet reduction might continue despite interest rate cuts.
The ECB is reviewing its operation framework, which is due to be finished by spring. The question is whether the central bank decides to keep a large amount of excess liquidity in the financial system via a large balance sheet like the Federal Reserve or whether it wants to create excess liquidity by providing loans to banks upon demand, as the Bank of England is doing. So far, policymakers are leaning toward the latter option, implying that the unwinding of the ECB balance sheet is likely to continue. Interestingly, roughly half of the outstanding TLTROs will expire in March and the remainder in December, building the case for an early interest rate cut. Reinvestments under the APP program have ended as of August 2023, representing a tapering of just under €30 billion per month on average in 2024. In the year's second half, the ECB will reduce reinvestments in the PEPP program by €7.5 billion a month to end them entirely in 2025, representing an additional tapering of €15 billion a month. With the APP program currently holding securities for €4 billion and the PEPP for €1.7 billion, it would take roughly a decade for the ECB to unload these holdings at the forecasted pace.
Economists are not excluding that we might see a reacceleration in inflation during the year's second half. Geopolitical risk is high, indicating that a rebound in commodity prices is possible despite weak demand. Unemployment remains at a record low, while wage growth is above 5% YoY. As inflation drops, real wages become positive, increasing demand. If the above were to happen, it’s unlikely that the ECB will be able to continue to ease the economy, putting ultra-long duration at risk.
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