European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.

Ultra-long duration: what can go wrong?

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.

1. The ECB might still not deliver six rate cuts as priced by markets.
   
   

   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.
   
   

2. 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.
   
   

3. Inflation might reaccelerate, calling for a halt of the rate-cutting cycle.
   
   

   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.
   
   

4. Japanese investors might prefer JGBs over EGBs.
   
   Even if the BOJ decides not to normalize monetary policies, Japanese investors might still not be compelled to buy European Government bonds (EGBs) at current levels. Ten-year Japanese government bonds pay 55 basis points. Excluding last quarter's peak in JGB yields, that's the highest they have paid in eight years. If Japanese investors were to buy 10-year German Bunds and hedge them against the JPY, they would record a nearly 2% loss. For these securities to become appetible again, hedge costs need to drop, or German Bunds need to offer a considerably higher yield.