The European Central Bank needs to fight rising government bond yields despite the hawks

Bonds
Althea Spinozzi

Fixed Income Strategist

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.

Source: Bloomberg and Saxo Group.

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.

Source: Bloomberg and Saxo Group.

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.

Source: Bloomberg and Saxo Group

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.

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.

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 and Product Disclosure Statement 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.

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.