European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024. European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024. European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.

European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  Sluggish growth and faster deflationary trends during the year's first quarter are likely to put the ECB's December macroeconomic projections at odds. At the same time, the upcoming end of the TLTRO facility might call for easier financial conditions, making a March ECB rate cut likely. Such a macroeconomic backdrop calls for a bull-steepening and disinversion of yield curves, building the case to extend one’s portfolio duration. Yet, it’s unclear whether the disinflationary trend will continue during the second part of the year as geopolitical tensions rise and deflationary base effects fade. Considering that the ECB Quantitative Tightening (QT) is likely to continue despite rate cuts, markets are likely to push back on aggressive rate cut expectations, and Japanese investors might prefer their domestic markets, we remain cautious of ultra-long duration.


Markets are starting the year with a clear picture in mind: prices will fall faster than anticipated due to a marked slowdown in economic activity. Therefore, policymakers will be forced to engage in interest rate cuts earlier and more aggressively than thought.

This picture looks particularly compelling in Europe. The consensus is for inflation to undershoot ECB’s projections throughout the year and for headline CPI to hit the central bank’s inflation target by the year's third quarter. Economists at Bloomberg paint an even more dovish picture: they expect headline inflation to fall below the central bank’s inflation target by the year's second quarter due to negative energy contributions. The core measure is expected to drop below 2% soon after as prices for food and goods stagnate throughout the year.

Such deflationary trends are unlikely to be accompanied by any optimism. The eurozone has suffered a downturn, and growth is forecasted to remain sluggish throughout the year. Eurostat says the number of bankruptcy registrations in the euro area is the highest since 2015. High-interest rates and lower economic activity are unlikely to slow down such a trend, suggesting that the ECB can't remain on the sidelines for long, building the case for early rate cuts.

Undershooting inflation is compelling for duration throughout the first half of the year.


Contrary to market expectations, rate cuts might already start in March.

Markets give only a 30% chance that the ECB will cut rates in March because policymakers are actively pushing back against early rate cuts, and investors discard the possibility that Lagarde might cut rates without the absolute certainty that Powell will follow suit. The focus is clearly on the euro currency, which, if devalued further, might bring an upside risk to inflation.

Yet, if CPI figures in January and February drop sensibly as economic activity lags, the ECB might be forced to revise its economic projections downwards. At the same time, half of the remaining TLTRO current balance is set to expire in March, making the need for easier monetary conditions likely.

Whether the first cut comes in March or April, the bull-steepening of yield curves is set into motion, with the German yield curve likely dis-invert.

Ten-year Bund yields have recently encountered strong support at 1.9% and are on their rise to test 0.382 retracement at 2.335%. If they break above this level, they are likely to rise to 2.6%. Yet, as inflation beats on the downside, there is room for yields to test and potentially break below 1.9% to find the next support at 1.73%. If the bond rally remains underpinned by deflationary trends and the ECB cuts rates by surprise in March, yields might test and break below this level, finding support next at 0.8%.

Source: Bloomberg.

Ultra-long duration: what can go wrong?

When talking about ultra-long duration, we refer to bonds that have a maturity longer than twenty years. These instruments have a high duration and are, hence, more sensitive to changes in interest rates. While the case to extend one's portfolio's duration remains compelling throughout the first half of the year, a more cautious approach is required for buy-to-hold ultra-long fixed-income securities.

  1. The ECB might still not deliver six rate cuts as priced by markets.

    Markets are pricing for up to 150bps rate cut by the ECB by the end of the year. Although the central bank might indeed cut by more than 25bps at a time, what is also true is that a rebound of inflation during the second part of the year might stall the rate-cutting agenda. If markets were to price out part of the rate cuts for this year, that would result in higher yield across the sovereign yield curve, weighting particularly heavily on bonds with ultra-long duration.

  2. The ECB’s balance sheet reduction might continue despite interest rate cuts.

    The ECB is reviewing its operation framework, which is due to be finished by spring. The question is whether the central bank decides to keep a large amount of excess liquidity in the financial system via a large balance sheet like the Federal Reserve or whether it wants to create excess liquidity by providing loans to banks upon demand, as the Bank of England is doing. So far, policymakers are leaning toward the latter option, implying that the unwinding of the ECB balance sheet is likely to continue. Interestingly, roughly half of the outstanding TLTROs will expire in March and the remainder in December, building the case for an early interest rate cut. Reinvestments under the APP program have ended as of August 2023, representing a tapering of just under €30 billion per month on average in 2024. In the year's second half, the ECB will reduce reinvestments in the PEPP program by €7.5 billion a month to end them entirely in 2025, representing an additional tapering of €15 billion a month. With the APP program currently holding securities for €4 billion and the PEPP for €1.7 billion, it would take roughly a decade for the ECB to unload these holdings at the forecasted pace.

  3. Inflation might reaccelerate, calling for a halt of the rate-cutting cycle.

    Economists are not excluding that we might see a reacceleration in inflation during the year's second half. Geopolitical risk is high, indicating that a rebound in commodity prices is possible despite weak demand. Unemployment remains at a record low, while wage growth is above 5% YoY. As inflation drops, real wages become positive, increasing demand. If the above were to happen, it’s unlikely that the ECB will be able to continue to ease the economy, putting ultra-long duration at risk.

  4. Japanese investors might prefer JGBs over EGBs.

    Even if the BOJ decides not to normalize monetary policies, Japanese investors might still not be compelled to buy European Government bonds (EGBs) at current levels. Ten-year Japanese government bonds pay 55 basis points. Excluding last quarter's peak in JGB yields, that's the highest they have paid in eight years. If Japanese investors were to buy 10-year German Bunds and hedge them against the JPY, they would record a nearly 2% loss. For these securities to become appetible again, hedge costs need to drop, or German Bunds need to offer a considerably higher yield.
Source: Bloomberg.
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.