The ECB will not abide by markets
Senior Fixed Income Strategist
Summary: We believe that the market is ahead of itself regarding ECB's interest rate hikes expectations. The ECB will most likely keep open the possibility to become less accommodative if inflation remains sustained. Still, it will discard interest rate hikes until 2023. It means short-term rates might tumble, forcing the EUR lower. Don't be fooled: positive German yields will soon be a reality across the yield curve as the central banks prepare to normalize monetary policy. Italian government bonds' honeymoon is over as market volatility remains sustained. We expect the BTPS-Bund spread to widen before resuming its decennial tightening trend.
This week, the market has advanced interest rate expectations in Europe. Money markets began to price 9bps of ECB tightening for July, sending shockwaves in the European sovereign space. Two-year German yields rose above the ECB deposit rate of -0.5% for the first time since 2015, in a sign that tomorrow Lagarde will lean against a rate hike in 2022. To foster such suspicions were the higher-than-expected inflation numbers released this week which showed a monthly pick up of 0.9% in Germany and Eurozone inflation rising to 5.1% YoY.
The ECB finds itself in a challenging position ahead of tomorrow's monetary policy meeting. On one side, it will want to retain the option open to fighting inflation. On the other hand, it needs to avoid igniting a deeper selloff in rates markets.
Therefore, the central bank is trapped. With the Federal Reserve and the Bank of England advancing with aggressive monetary policies this year, the euro area's yields will also rise. Additionally, the PEPP program is ending in March, pulling even more economic support and applying upward pressure to rates. That would cause a natural tightening of financing conditions in the euro area, which the ECB would want to monitor.
Therefore we’ll probably see Lagarde pushing back against a rate hike this year, disappointing on the market's hawkish expectations. We could witness a contained rally in European sovereigns, which could tumble the EUR.
Don’t be mistaken: ten-year Bund yields might have become a memory already this week. Any hawkish or dovish shift of the ECB will be mostly felt by the front part of the yield curve. However, it's undeniable that the whole German yield curve willsettle above 0% as the ECB gets ready to normalize its monetary policy.
Italian government bonds’ honeymoon is over.
The celebrations for the re-election of President Mattarella were short-lived. After a modest tightening of the BTP-Bund spread on Monday, the spread resumed rising yesterday. It shows that the performance of Italian government bonds does not depend entirely on the national political situation. At this moment, they are more vulnerable to central banks’ monetary policies.
Because BTPS carry a higher beta than peers, Italian sovereigns will suffer the most as volatility in rates markets increases. Therefore, we remain constructive on our view that the BTPS-Bund spread will widen to 160bps before resuming its tightening decennial trend.
Latest Market Insights
Quarterly Outlook Q3 2022: The Runaway Train
- Central banks' attempts to kill inflation is a paradigm shift, which could end in a deep recession.
Tangible assets and profitable growth are the winnersWith US equities officially in a bear market, the big question is where and when is the bottom in the current drawdown?
Understanding the lack of investment appetite among oil majorsThe everything rally seen in recent quarters has become more uneven, as its strength is driven by commodities in short supply.
The pressure is on as the wind leaves the sailsWith cryptocurrencies in sharp decline, are we entering a crypto winter or is the bear market a healthy clean-up of the crypto space?
Why the Fed can never catch up and what turns the US dollar lower?Many other central banks are set to eventually outpace the Fed in hiking rates, taking their real interest rates to levels higher than the Fed will achieve.
Bank of Japan: Swimming against the tideThe Japanese economy has gone from the age of deflation to rapidly rising prices in no time, leaving the Bank of Japan in a pickle.
Green transformation detour and bear market hibernationWith the impending risk of global econonomic derailment, we share the five things investors need to consider in this new half year.
Crisis redux for the eurozone?Whether there's going to be a recession in Europe or not, the path towards a stable economy will be agonizing.
Technical Outlook: Gold, Oil and a remarkable multi-decade perspective on EquitiesThe Nasdaq bubble pattern, USDJPY resistance, crude oil uptrend losing steam and the technical outlook for USD.
China: the train of new development paradigm left the station two years agoChina is transiting to a new development paradigm, as they are hit by deteriorating terms of trade, a slower global economy and an uncertain future while continuing attempts to contain the pandemic.