Head of Fixed Income Strategy
Summary: The European Central Bank (ECB) is unlikely to push against markets' expectations of a rate cut in June. This, coupled with a downward revision of the staff macroeconomic projections in inflation and growth for this year, gives European sovereigns room to gain across maturities. Even in the most hawkish scenario, where the forecasts show inflation to stay well above 2% for the rest of the year, the German yield curve doesn't have much space to bear-flatten considerably as rate cuts will still be expected in the near future due to the ongoing disinflationary progress. It is, therefore, compelling to extend one portfolio's duration up to the ten-year tenor. However, investors may need to wait a little bit longer for a bond bull rally. Indeed, the waning down of the Pandemic Purchase Program (PEPP) will start in June, and a new monetary policy framework will be announced in the spring. That's why we expect sovereign bond yields to trade rangebound until the rate-cutting cycle begins.
Although the three-month and six-month annualized headline and core CPI rates suggest that price pressures in Europe are below the ECB target, they are also showing signs of bottoming.
Recent monthly inflation data, have been lower than expected, leading to a probable revision of the ECB's inflation staff projections for 2024. The question is, to what extent?
Market expectations are for headline inflation to drop to 2.3% this year, while core inflation is expected to remain around 2.5%. That's much lower than the 2.7% for core and headline CPI showed by the ECB staff projections in December 2023.
GDP forecasts are also crucial since preliminary data show weaker growth than expected by the latest ECB staff projections.
1. Dovish scenario (bullish for bonds). The ECB's macroeconomic projections align with market expectations. As a result, the probability of a rate cut in April will increase, triggering a bull-steepening of the yield curve. This will benefit all maturities across the yield curve.
2. Base scenario (bullish for bonds). The new staff forecasts show headline inflation close to target in 2024 but they will not revise 2025 inflation downwards. In such a scenario, the German yield curve is also likely to bull-steepen. However, long-term rates will remain somewhat supported as the projections indicate that the central bank will need to be cautious about cutting rates too aggressively.
3. Hawkish scenario (bearish for bonds). The projections show inflation to remain well above target throughout 2024, with Lagarde ruling out an April cut. In this case, the yield curve is likely to bear-flatten slightly, but not significantly, because the ECB will confirm its intention to begin cutting rates in a few months.
It's important to remember that in any of the situations mentioned above, the European Central Bank (ECB) will still be preparing to gradually reduce its Pandemic Purchase Program (PEPP) starting from June. Additionally, the ECB will make a decision on a new monetary policy framework in the coming weeks. Consequently, European sovereigns will likely continue trading rangebound until the first interest rate cut occurs. Hence, any bond gain next week may wane in the following weeks.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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