Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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ECB preview: it can only be a pause
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Rising long-term yields, uncertainty surrounding war in the Middle East, and rumors of the Bank of Japan tweaking yield curve control next week are setting the stage for the ECB to pause at this week's monetary policy decision. Markets will be interested in discussions concerning the Pandemic Emergency Purchase Program (PEPP); however, with the BTP-Bund spread widening, it’s unlikely that the ECB will signal to stop reinvestments under this program. As the central bank sticks to the higher-for-longer message, yield curves will continue to bear-steepen on both sides of the Atlantic. Therefore, we favor short-term government bonds and remain wary of duration.
Rising long-term yields and uncertainty concerning the conflict in Israel will force the ECB to remain on hold at this week’s monetary policy meeting.
Since the beginning of September, 10-year US Treasury yields rose by roughly 90bps from 4.10% to 5% today, forcing European sovereign yields also higher. German 10-year yields aim to reach 3% for the first time since 2011, and Italian sovereign yields are at their highest since 2012 in the wake of the European sovereign crisis. Higher long-term rates are tightening the economy further, leaving little reason for another interest rate hike.
At the same time, the ECB has a limited amount of new information to tweak its monetary policy further. The Bank Lending Survey, third-quarter GDP data, and a new round of staff projections will be available only by the December monetary policy meeting. Therefore, the focus at this meeting shifts toward policymakers' conversation about non-interest rate monetary policy tools such as minimum reserve requirement and an early end of reinvestment of the Pandemic Emergency Purchase Program (PEPP).
Yet, it is unlikely that the PEPP program will be disinvested anytime soon. As yields continue to rise, the BTP-Bund spread rose to 200bps, threatening to increase further amid volatility. As the central bank remains concerned about funding squeezes in the periphery, particularly in Italy, it will take a lot to alter the PEPP program.
The focus is on US Treasuries and the Japanese investors.
This week, European sovereigns will be sensitive to the direction of US Treasuries and decisions concerning the BOJ's Yield Curve Control. The rise in yields seems unstoppable for the following reasons:
1. Inflation expectations are rising again; hence, central banks might need to hold rates higher for longer. Geopolitical tensions in the Middle East put upward pressure on inflationary pressures. The 10-year breakeven rate rose to 2.47% recently from 2.10% in March. The 5-year 5-year Forward rate and 10-year CPI swap are rising again towards 3%, indicating that high inflation might persist.
2. Quantitative Tightening (QT) and an increase in US Treasury auction sizes put upward pressure on yields. The Federal Reserve and ECB engage in QT, implying that central banks do not support bond prices. At the same time, the US Treasuries had to increase T-Bills and coupon supply to finance a large fiscal deficit. While bond supply remains at pandemic levels, the Federal Reserve is not supporting such issuance.
3. The Bank of Japan might further tweak yield curve control (YCC). Next week, the BOJ will release its policy board members' economic forecasts. As of July, headline inflation was expected to end the year (April 2024) at 2.5%. Yet, CPI remains well above 3% so far, making an upward revision at the October meeting likely. At the same time, rising yields worldwide also call for a further tweak of YCC policies. The Nikkei newspaper reported on Sunday that the BOJ might be considering raising the 1% ceiling or removing the allowance band set around the 0% target. Either way, such moves will deter foreign investors from buying US Treasuries and European sovereigns, putting more upward pressure on yields.
By now, Japanese investors have no reason to buy US Treasuries and European sovereign bonds as the cost of hedging this position is high and hence, it is more profitable to buy JGBs at 0.85% outright.
What does that mean for the EUR bond market?
As European sovereign bonds are closely correlated to US Treasuries, European yields will also rise as yields continue to increase in the US. It is, therefore, safe to assume yield curves will continue to steepen, with long-term yields rising faster than short-term yields.
Front-term yields will remain anchored as markets believe that central banks are at the peak of their hiking cycle. Therefore, we continue to favor the front part of the yield curve and quality going into central banks' monetary policy meetings while we remain cautious about duration. Click here to find bond ETFs, which can give exposure to various parts of the yield curve.
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