Head of Fixed Income Strategy
Although disinflation in the Eurozone has accelerated since the start of the year, 2-year Schatz yields have increased by 50 basis points, rising from 2.4% to 2.9%. Front-term yields are closely tied to policy rates, reflecting investor sentiment opposing expectations of an imminent aggressive interest rate-cutting cycle. In fact, at the beginning of January, bond futures were pricing 160 basis points of rate cuts for 2024, compared to 85 basis points today.
During the same period, 10-year bund yields increased from 2% to 2.4%. This is significant because the performance of the long end of the yield curve is less influenced by monetary policies and relies more on inflation expectations and the economy's overall shape.
Bunds might convey a powerful message: long-term yields might remain sticky amid market resilience. Indeed, signs of a Eurozone recovery are underway despite the ECB deposit facility rate remaining at 4%. Upcoming rate cuts might improve growth but weigh on the euro currency, increasing the risks of another wave of energy inflation, leading to a cautious approach by policymakers.
Market consensus is that the upcoming European Central Bank (ECB) meeting will lay the groundwork for a potential rate cut in June. This expectation finds support in recent policymakers’ communications, which indicate a willingness to pivot toward normalizing monetary policy to a neutral stance as supply shocks continue to unwind.
The recent ECB Minutes confirmed the bias for a June rate cut: "(...)in addition to new staff projections, the Governing Council would have significantly more data and information by the June meeting, especially on wage dynamics. By contrast, the new information available in time for the April meeting would be much more limited, making it harder to be sufficiently confident about the sustainability of the disinflation process by then.”
Consequently, market expectations have shifted from pricing in 40 basis point rate cuts by April at the beginning of the year to completely eliminating the chances of a rate cut this month and gradually adjusting forecasts for the rest of the year.
We concur with the anticipated rate cut in June, followed by a pause in July. However, three consecutive rate cuts in September, November, and December may not be justified if the Federal Reserve remains cautious.
The ECB has expressed concerns regarding the sluggish decrease in services inflation, which indicates persistent inflationary pressures in specific segments of the economy that are more wage-sensitive. This "last mile" of inflation presents a challenge for the ECB, necessitating a careful approach to wage growth and policy adjustments to ensure that inflation expectations remain well-anchored within target.
Strong wage growth has contributed to domestic price pressures. Although wages seem to have peaked at the beginning of 2024, it makes sense that the central bank is looking for more indications that wages are normalizing before engaging in a rate-cutting cycle, especially in the context of improving growth.
Signs of economic activity bottoming out, coupled with slightly faster-than-expected easing of inflationary pressures, create a delicate balance for the ECB. The need to support growth without prematurely easing monetary conditions highlights the complexity of the timing and extent of the anticipated rate cuts.
While the ECB's decision to start a cutting cycle is mainly influenced by internal economic indicators and inflation trends, it is also affected by the global monetary policy environment, particularly the Federal Reserve's policy stance. Should the Federal Reserve delay its rate-cutting cycle, the ECB might find itself in a position where it has to moderate its own cutting cycle. This is primarily because a significant policy divergence could lead to a weaker euro relative to the dollar.
The Eurozone’s export-oriented growth model may benefit from a weaker euro, especially in light of the risks of new U.S. tariffs in case Donald Trump returns to the white house. However, since Europe imports a substantial amount of commodities priced in dollars, a weaker euro could inadvertently fuel inflation by increasing the cost of imports. This dynamic could compel the ECB to adopt a more cautious approach to rate cuts, aiming to balance the need to support growth while keeping a close eye on inflationary pressures that might arise from currency depreciation.
Because even in the remote event of a second inflation wave, investors holding 2-year sovereigns are unlikely to run losses, as yields on these tenors need to more than double, implying another aggressive interest rate equal in intensity to the one we just came out from.
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