Head of Fixed Income Strategy
Summary: Today's 10-year Bund auction has reinforced our view that the ECB will not have the chance to be hawkish at tomorrow's monetary policy meeting. Although the macro-economic backdrop is improving, the economy remains vulnerable. Lagarde will most likely reinforce the central bank's dovish stance and highlight the importance to keep European bond yields in check. Thus, we don't see an upside in shorting the Bunds yet.
The market focus at tomorrow's ECB monetary policy meeting will be the growing divide between hawks and doves, which poses a threat to investors in terms of the ECB's forward guidance. A stronger-than-expected economic recovery might not warrant further action from the central bank. However, the rising cost of funding in the Euro area remains a problem.
Klaas Knot, the Dutch central bank chief, has recently said that if the economy continues to improve, he doesn't see why the ECB will not gradually phase-out of the pandemic emergency purchases under PEPP by the end of this year to finally end the program in March 2022 as expected. We believe that Knot might be running way ahead of himself for several reasons:
1. The Covid-19 pandemic might not be over yet: despite an acceleration in the pace of vaccination, there is still the probability that another wave may hit the European Union by autumn. It's a risk that the market is not pricing yet because it blindly wants a recovery, which will undoubtedly come but might be choppy.
2. The end of the pandemic might not come together with a full economic recovery. There is the possibility that the PEPP program might be extended beyond March 2022 for the simple reason that the economy will not be fully recovered by the end of this year.
3. It’s unlikely that the ECB will move ahead of the Federal Reserve in terms of tapering. The United States will see a recovery sooner than the euro bloc for the simple reason that monetary e fiscal policies have been working hand in hand. In Europe, fiscal stimulus is lagging, and the money agreed under the recovery fund need to be still disbursed. The Fed expects to taper at the beginning of 2022 at the earliest despite higher inflation and economic expectations. There is no chance that the ECB will move before the Federal Reserve, especially if inflation expectations continue to lag.
4. Tapering means tightening the bloc’s financial conditions, and the European corporate sector is not ready for it. When we speak about rising bond yields in the euro area, we talk about the higher cost of funding for European corporates. While it’s fair to say that a recovery might improve companies' balance sheets, it's also important to acknowledge that the Euro STOXX 600 holds the highest leverage ratio since early 2000. Higher leverage has been possible thanks to the ECB aggressive monetary policies, which reduced significantly borrowing costs. If interest rates suddenly rise, weaker companies relying on capital markets will find it challenging to refinance their debt and risk default.
We believe that the ECB will need to continue to fight rising yields in the euro area because of the points listed above. The central bank will use all the tools in its power to do so, although it will be an uphill battle if US Treasury yields continue to rise.
Bunds are telling us that the ECB will maintain its aggressive stance
Strategists from the Street have been vocal about an opportunity opening up for bond traders: the possibility that the ECB will disappoint the market, providing the perfect opportunity to short the Bunds.
However, we are receiving opposite signals from the market. The bid-to-cover ratio at today's 10-year Bund auction was spot on with the 5-year average. It means that sentiment in Bunds is neither bullish nor bearish.
Throughout the day, sentiment improved considerably, with 10-year yields breaking below the ascending trend channel they have been trading since the beginning of the month.
Because European bond yields are falling today, the ECB might not double down the message that it will keep yields in check tomorrow. Yet, a potential selloff will most likely be limited to a correction of few basis points. The worst of the hypothesis is that Bunds test the upper resistance line at -0.21%, representing a change in Bunds' cash price of 0.5%. Hence, we don’t see much upside into shorting bunds ahead of the ECB meeting and remain neutral.
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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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