Italian BTPs are more attractive than Bunds in today's macroeconomic context

Summary:

• Italian BTPs are appealing asset in the event of persistent inflation, as they provide a stronger hedge against it.
• Their correlation with the Bunds puts them in a position to also benefit in the event of heightened tensions in the Middle East.
• Concerns about a weak euro leading to a second wave of inflation will limit the ECB rate cutting cycle, weighing on the Bunds and leaving long-term rates volatile.

Despite the ECB's preparations to cut rates, european sovereign bonds continue to decline. This can be attributed to the surge in commodity prices sparked by potential escalations in Middle East conflicts, hinting at sustained or even increased inflation in the latter half of the year.

Inflation plays a crucial role in bond performance. If it remains high, the chances of a bond bull rally are slim, as central banks would struggle to implement aggressive rate cuts. Expectations for Fed rate cuts in 2024 have dwindled from nearly six to less than two, while in Europe, they have decreased from almost seven to three.

Despite expectations that the ECB would be more aggressive in cutting interest rates than the Federal Reserve, this divergence hasn't halted the rise in Bund yields. Starting the year at 2%, ten-year yields have climbed to nearly 2.5%, showing an upward trend that could push them to test resistance at 2.5% and potentially reach 2.75% if breached.

Several factors could drive Bund yields higher:

• Slower progress in disinflation: With core inflation hovering around 3% in the eurozone, the ECB's real policy rate stands at approximately 100 basis points. If inflation persists around this level, the ECB's room to cut rates to stimulate the long end of the yield curve would be limited.
• Uncertainty surrounding the rate cut cycle: Policymakers have signaled their intent to cut rates in June but are managing expectations beyond that to prevent markets from anticipating aggressive cuts.
• Concerns about a weak euro leading to a second wave of inflation: ECB President Lagarde's recent remarks concerning the impact of currency fluctuations on inflation underscores this concern and should not be ignored. A weaker euro is good for European growth, but if it weakens too much it might provoke a rise in inflation. That will limit policymakers ability to cut rates.

Ten-year Bunds still offer an attractive risk-reward profile.

Assuming a one-year holding period, yields would need to exceed 2.8% to result in a loss. Considering the potential for persistent inflation or economic recovery, the upside of such a position in the event of a market downturn or disinflationary trends cannot be ignored. For instance, if 10-year Bund yields were to drop from 2.46% to 1.46%, the position would yield an 11% upside.