Head of Fixed Income Strategy
Summary: Don't be fooled by today's European Central bank's "dovish taper". With the German elections, reality will dawn on investors: rates will inevitably soar regardless of the ECB's monetary policies. We believe that today's mini-rally is the golden opportunity to short Bunds even cheaper.
A "dovish taper" has been delivered to perfection by the European Central Bank. The market was expecting the ECB to reduce the pace of bond purchases under the PEPP but remained uncertain about the surrounding message. The central bank resolved any doubt by putting black on white the following:
“The Governing Council will purchase flexibly according to market conditions and with a view to preventing a tightening of financing conditions that is inconsistent with countering the downward impact of the pandemic on the projected path of inflation. In addition, the flexibility of purchases over time, across asset classes and among jurisdictions will continue to support the smooth transmission of monetary policy. If favourable financing conditions can be maintained with asset purchase flows that do not exhaust the envelope over the net purchase horizon of the PEPP, the envelope need not be used in full. Equally, the envelope can be recalibrated if required to maintain favourable financing conditions to help counter the negative pandemic shock to the path of inflation[1].”
In essence, the ECB says that rates will need to stay low until the pandemic is finished and the inflation target of 2% is reached. In case financial conditions tighten, thus rates rise, the ECB can still use PEPP’s full envelope or recalibrating it to counteract this trend.
To explain such a dovish decision might be the central bank’s macroeconomic projections which see inflation rising faster than previously expected for 2022 and 2023, yet, well below the ECB’s target.
[1] https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.mp210909~2c94b35639.en.html
Although the bond market is complacent with Lagarde's message today, we believe that the ECB will have a tough time keeping European rates in check during the last part of the year. We identify two main catalysts that will contribute to higher rates:
(1) German elections. As per the latest polls, the SPD is leading the CSU/CDU party. Although the greens have lost some support recently, it looks they could be still part of the next government. That should translate into more Fiscal spending, hence more Bund issuance that will push yields higher.
(2) Positive correlation with the US Treasuries. We expect yields to rise in the US and drift yields higher in Europe, too. On one side, if an agreement over the debt ceiling is not reached soon, it will increase the risk of a Quantitative Tightening (QT) in October /November. Indeed, the later a decision is taken, the larger the volumes of Bills the US Treasury will need to issue in a short time to refinance existing debt by the beginning of November. On the other hand, the longer the Federal Reserve delays tapering, the more aggressive it will need to be, provoking a fast rise in yields.
We expect 10-year Bunds to break above 0% by year-end and stabilizing around 0.2%. As a consequence, European Government bonds will need to reprice accordingly. We are particularly bearish Greece, France, Portugal and Spain. We remain neutral on Italian BTPS as we see still scope for the BTPS/Bund Spread to tighten to 75bps by the end of the year. However, it doesn't mean that yields won't rise in Italy, too. We expect them to stabilize between 0.9% to 1%.
We remain of the idea that this is a golden opportunity to take advantage of cheaper valuations to short the bond market, as we have outlined in our recent piece.
Euro-Bund put-options with December expiry, 169 strike and Delta 20 have cheapened considerably and are now pricing at 0.360 while on Tuesday were trading at 0.470.
If you are not comfortable with put options, you can look at ETFs shorting European sovereigns such as:
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