Head of Fixed Income Strategy
Summary: European sovereign yields remain in an uptrend as markets price for two more rate hikes this year. However, as chances of a hiking pause across the Atlantic are high, the tail risk that the ECB might flirt with the idea of skipping a rate hike in July becomes plausible. If Christine Lagarde's remarks are not hawkish enough, or/and she signals a hike skip in July, or/and the ECB macroeconomic projections show a much gloomier economy, European sovereign yields might drop this week. Yet, a sovereign rally will be counterproductive to the ECB's current goal of fighting sticky core inflation. Even if such a policy mistake is made, it will force the ECB to return to its hawkish tone soon after. Thus, German yields will remain under pressure in the next few months, especially at the front end of the yield curve.
May’s ECB minutes and recent ECB member speakers said it clearly: inflation is stubbornly high; hence more interest rate hikes are needed. This message resonates with policymakers as the real benchmark ECB deposit rate (the spread between the deposit rate and yearly core inflation) remains below the ECB expansionary policy era even if the central bank hiked rates by 400bps. However, with another 25bps hike and falling core CPI data on Thursday, the ECB will finally bring the real benchmark rate to the bottom range it has been trading in since 2010.
Although the real benchmark rate will still be too low to fight sticky inflation, policymakers might see that as a sign that they are getting into a sweet spot and are not far from the finish line. After all, data-driven monetary policy is rear looking, and it might take some time for the effects of an unprecedented hiking spree to reflect in the economy.
With Federal Reserve officials across the Atlantic signaling that a pause might be warranted this month, it's hard not to envision dovish members of the ECB thinking the same.
Therefore, while markets confidently price another two ECB rate hikes in June and July, the ECB might mimic the Fed and hint at a skip in July, moving interest rate hiking odds to September.
Currently, the market is pricing a 75% chance of a hike in July and a 41% chance in September. Wiping out chances for a hike in July means there might be an upside for short-term European sovereigns this week, particularly for 2-year government bonds, which sentiment is tightly linked to monetary policies. However, a revision of the ECB staff projections will dictate whether such a rally will be short-lived as the central bank needs to consider weaker growth and sticky core inflation.
In March, the ECB macroeconomic staff projections showed the economy recovering quickly, with growth matching the pre-pandemic yearly rate of 1.6% in 2024. The same forecasts showed inflation to remain above the 2% target until 2025.
The picture of a growing economy able to decelerate inflation doesn’t resonate with economists. That’s why it’s likely that at this meeting, the ECB macroeconomic forecasts might entertain a gloomier economic outlook. The gloomier the ECB’s macroeconomic forecasts, the more dovish the market expects the ECB to be in the future, driving long-term yields lower. However, if the projections are not as gloomy, the “higher for longer” message will better resonate with investors, and front-end yields still have a chance to rise.
Since the end of May, the 2-year German swap spread dropped sensibly. The move has been caused by quickly rising 2-year Schatz yields. A drop in yields might erase June’s downward move in swap spread. That will bring us back to square one: if inflation is sticky, the ECB needs to do more to fight it; hence front-end sovereigns will remain under pressure in the upcoming months.
As the macro-economic backdrop looks now, a sovereign rally is unsustainable in the next few months, even if the ECB hints at a July skip this week. Two-year yields are in an uptrend. They have broken above their symmetrical triangle and are rising towards 3%, where they'll find strong resistance and might bounce back. If they break the 3% level, they will find resistance next at 3.13%.
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