Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Strong trade-weighted EUR gives ECB green light to cut rates, but bond bull rally unlikely
Althea Spinozzi
Head of Fixed Income Strategy
Summary:
- Front-term rates are likely to drop as the ECB begins to cut rates. However, long-term sovereigns remain vulnerable to persistent inflation and an improving macroeconomic backdrop.
- The EUR is strong on a trade-weighted basis, allowing the ECB the flexibility to begin cutting rates. However, if the EUR/USD falls below 1.068, policymakers are likely to become more concerned about the currency's weakening, forcing them to be less dovish.
- As the winddown of the PEPP facility starts in July, Italian sovereign bonds will face pressure. However, investors' appetite for higher-yielding securities might offset this trend.
- We continue to favor short-term maturities up to three years, particularly 2-year Italian BTPs, which offer an appealing risk-reward ratio. The yield on these securities would need to rise above 8.8% to incur a loss, assuming a one-year holding period.
ECB policymakers have widely signaled a rate cut in June, with the swap market pricing in the likelihood of three rate cuts within the year.
To evaluate whether a bond bull rally is imminent in the euro area, it is essential to consider the following factors:
1. Eurozone economic forecasts indicate sticky inflation and an economic recovery.
The European Commission's recent economic forecasts indicate that inflation may reach its target sooner than expected, with HICP revised downward compared to winter projections. Inflation is expected to fall to 2.5% in 2024 and 2.1% in 2025. However, euro area GDP growth has been revised down by 0.1 percentage points for 2025, now forecasted at 1.4%.
This data could set the stage for a bond rally due to disinflationary pressures and a slightly slower-than-expected economy. However, it is crucial to consider the current situation: core CPI remains closer to 3% than 2%, and inflation is not forecasted to hit the target for another two years. At the same time, the eurozone economy is recovering from a real GDP growth of 0.4% in 2023 to 1.4% in 2025, therefore a recession is not in the cards. This macroeconomic backdrop is supportive for risky assets, putting at risk safe havens such as German Bunds.
2. The Euro remains strong on a trade-weighted basis.
One reason the ECB is cutting rates ahead of the Fed without concern for EUR depreciation is that the euro remains above its historical average from a trade-weighted perspective. The Euro Trade Weighted Index (TWI) considers the euro's relative strength against a basket of foreign currencies, weighted according to the Eurozone's trade volume with each respective country.
The trade-weighted index (TWI) for the euro is currently above its average since 2010. However, if the EUR/USD exchange rate dips below 1.068, the TWI will fall below this average. Despite this, policymakers are likely to view the euro's trade-weighted value as acceptable, allowing them to proceed with rate cuts.
Markets are already pricing in three rate cuts by the ECB by year-end, and the current EUR/USD exchange rate reflects these expectations. If these cuts do not materialize, or if the Federal Reserve adopts a more dovish stance than anticipated, there is the chance that the euro will strengthen against the USD.
3. Geopolitical tensions signal increased volatility and inflation risk.
Given that geopolitical tensions are unlikely to dissipate soon, markets will probably remain volatile, and the risk of persistent inflation will increase. This scenario could keep bond markets on edge, leading investors to demand a higher premium due to increased volatility and inflation risk.
What does it means for European sovereign markets?
Before addressing this question, it's important to review the performance of European sovereign bonds from the beginning of the year to today. Traditional safe havens like German sovereign bonds have underperformed their peers, while Italian BTPs have outperformed.
While it might seem logical to attribute this to economic performance—Germany experienced a recession, whereas southern European economies did not—the outperformance can be explained by basic investor logic. Inflation has not yet returned to the ECB’s 2% target and is not expected to do so for another couple of years. Meanwhile, the European economy has started to recover. Investors may favor Italian BTPs over German Bunds simply because the former offers a much higher yield, providing a better buffer against potential inflation resurgence.
Going forward Italy government bond outperformance will be put at a test. In the second half of the year 261 billion Italian sovereigns are coming to maturity. At the same time the ECB is going to start to wane down the Pandemic Emergency Pandemic Programme (PEPP) starting from July.
Therefore, persistent inflation and an economic recovery could be the lifeline for Italian BTPs. Yield-hungry investors are likely to favor higher-yielding securities over safe havens, helping to counteract the pressures from the winding down of the PEPP.
Below, we examine German, Italian, and Spanish sovereigns from a risk-reward perspective. In a negative scenario, short-term Italian BTPs are more resilient, particularly with 2-year BTP yields.
Other recent Fixed Income articles:
14-May UK labor data and Huw Pill's comments are not enough for a bond bull rally
08-May Bank of England preview: Rate cuts in mind, but patience required.
06-May Insights into this week's US Treasury refunding: 3-, 10-, and 30-year overview
02-May FOMC Meeting Takeaways: Why Inflation Risk Might Come to Bite the Fed
30-Apr FOMC preview: challenging the March dot plot.
29-Apr Bond Markets: the week ahead
25-Apr A tactical guide to the upcoming quarterly refunding announcement for bond and stock markets
22-Apr Analyzing market impacts: insights into the upcoming 5-year and 7-year US Treasury auctions.
18-Apr Italian BTPs are more attractive than German Schatz in today's macroeconomic context
16-Apr QT Tapering Looms Despite Macroeconomic Conditions: Fear of Liquidity Squeeze Drives Policy
08-Apr ECB preview: data-driven until June, Fed-dependent thereafter.
03-Apr Fixed income: Keep calm, seize the moment.
21-Mar FOMC bond takeaway: beware of ultra-long duration.
18-Mar Bank of England Preview: slight dovish shift in the MPC amid disinflationary trends.
18-Mar FOMC Preview: dot plot and quantitative tightening in focus.
12-Mar US Treasury auctions on the back of the US CPI might offer critical insights to investors.
07-Mar The Debt Management Office's Gilts Sales Matter More Than The Spring Budget.
05-Mar "Quantitative Tightening" or "Operation Twist" is coming up. What are the implications for bonds?
01-Mar The bond weekly wrap: slower than expected disinflation creates a floor for bond yields.
29-Feb ECB preview: European sovereign bond yields are likely to remain rangebound until the first rate cut.
27-Feb Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.
23-Feb Two-year US Treasury notes offer an appealing entry point.
21-Feb Four reasons why the ECB keeps calm and cuts later.
14 Feb Higher CPI shows that rates volatility will remain elevated.
12 Feb Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.
06 Feb Technical Update - US 10-year Treasury yields resuming uptrend? US Treasury and Euro Bund futures testing key supports
05 Feb The upcoming 30-year US Treasury auction might rattle markets
30 Jan BOE preview: BoE hold unlikely to last as inflation plummets
29 Jan FOMC preview: the Fed might be on hold, but easing is inevitable.
26 Jan The ECB holds rates: is the bond rally sustainable?
18 Jan The most infamous bond trade: the Austria century bond.
16 Jan European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.
10 Jan US Treasuries: where do we go from here?
09 Jan Quarterly Outlook: bonds on everybody’s lips.
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