Head of Fixed Income Strategy
Summary: As markets are precipitously pricing an aggressive ECB pivot next year, there is no guarantee that core inflation won't remain sticky, causing policymakers to push back on rate cut expectations. As discussions surrounding the end of PEPP reinvestments will begin, it's unlikely that the ECB will pivot before next June unless the recession becomes deeper. As bond futures are pricing for 150 basis points rate cuts next year, the chances are higher for markets to price out rate cuts rather than more. That leaves sovereign bonds at risk of repricing.
While the recent U.S. bond bull market is based on assumptions of a soft landing, the drop in yields we are witnessing in the old continent is driven by expectations of a deep recession, ultimately killing inflation.
To confirm such a notion was the recent speech of Isabel Schnabel, saying that a faster-than-expected slowdown in inflation was a pleasant surprise, evidence that tighter financial conditions are working and that further interest rate hikes might not be needed. That was enough to fuel speculations that the ECB will be the first among G7 countries to cut interest rates as early as April and to be the most aggressive compared to peers, cutting by 150 basis points by year-end. Such expectations fueled an everything rally, with the Stoxx 600 index rising 9% since its October low and German Bund yields dropping to 2.25% from their 2.96% October high.
The problem with the above is that such a rally is based on the notion that inflation is dead and could soon fall below target. Yet, the core Eurozone inflation in the euro area remains at 3.6%, and there are signs that inflation can remain sticky for some time due to wages and the withdrawal of certain support measures, such as price caps and VAT relief.
To better understand when the ECB would likely cut rates, it is essential to consider PEPP reinvestments. Recently, Lagarde said that the PEPP will soon be discussed. That means the earliest date for PEPP reinvestment to end is January 2024. It is unlikely that guidance for rate cuts will come at the following monetary policy meeting unless a deep recession or a tail event presents itself. That makes the first rate cut more likely in June rather than April.
That means markets can push back on expected interest rate cuts, causing sovereign yields to rise again.
Ten-year Bund yields broke below their 50-day simple moving average yesterday. Although they will find support around 2.15%, stronger support will be met at 1.91%. That would be the lowest since March this year, amid the SVB crisis.
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