Head of Fixed Income Strategy
Summary: European sovereigns fell even though the ECB delivered more than expected. The market is failing to see that more stimulus is ahead as the central bank will need to continue to stimulate the economy to revive inflation. However, the good news is coming from the EU Summit as Hungary and Poland lift their veto on the EU recovery fund. Thus, more upside is ahead for periphery with Spanish 10-year yields poised to dive below zero within days and the spread between BTPs and the Bund to fall below 100bps in the first quarter of 2021.
This year's Santa Claus has a name: Christine Lagarde. What she's bringing to every European household is the hope for economic recovery and ever high bond prices.
There is no need to wait for the Christmas day to have the presents delivered. As a matter of facts, there wasn't even need to wait for the ECB meeting today to see European sovereigns moving up to unprecedented highs. The market has been pricing more stimulus from the central bank for more than a week. Portuguese 10-year yields dived below zero on Tuesday, and Spanish 10-year yields toyed with this level today as they touched 1bps before the ECB rate announcement. In the morning, European rates fell considerably without even blinking to the possibility that the ECB might disappoint.
Indeed Christine Lagarde did not disappoint and announced an extension of the Pandemic Purchase Program (PEPP) until March 2022 and boost it by €500 billion. The TLTROs programme also was extended until June 2022. These measures exceeded market expectations, but they failed to give an additional boost to European sovereigns.
Seeing European rates pointing higher after the ECB announcement was a complete surprise. The ECB bluntly said that it is willing to give unlimited support to the European economy until there is a stable recovery and the inflation target is not met. Besides, Hungary and Poland lifted their veto over the EU recovery fund, pointing to the fact that there will be no lack of stimulus next year.
To strengthen expectations of more stimulus coming in the next few years, the ECB forecasted inflation at 1.3% in 2023, which is well below the central bank's target. The ECB might not have come in in full force today because it is expecting that more stimulus might be needed in the next few years. After all, inflation is nowhere near its target.
These are bullish news for the credit space.
Investors should not be discouraged by low or negative yields in the Euro area because the graph below is showing that there is still more room for tightening. The option-adjusted spread of European sovereigns and credits is still wider compared to what it was before the Global Financial Crisis of 2008. It means that if the ECB wants to, it can do a lot more than what it is doing now. Hence, the periphery will resume rallying.
As explained in an earlier analysis, we are seeing the spread between 10-years BTP and the Bund falling below 100bps. At the same time, the spread between 30-year BTP and the Bund will most likely fall to 120 bps withing the first half of 2021. This means that longer dated Italian government bonds have an upside of 10% in capital appreciation.
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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.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
