The ECB will not abide by markets

The ECB finds itself in a challenging position ahead of tomorrow's monetary policy meeting. On one side, it will want to retain the option open to fighting inflation. On the other hand, it needs to avoid igniting a deeper selloff in rates markets.

Therefore, the central bank is trapped. With the Federal Reserve and the Bank of England advancing with aggressive monetary policies this year, the euro area's yields will also rise. Additionally, the PEPP program is ending in March, pulling even more economic support and applying upward pressure to rates. That would cause a natural tightening of financing conditions in the euro area, which the ECB would want to monitor.

Therefore we’ll probably see Lagarde pushing back against a rate hike this year, disappointing on the market's hawkish expectations. We could witness a contained rally in European sovereigns, which could tumble the EUR.

Don’t be mistaken: ten-year Bund yields might have become a memory already this week. Any hawkish or dovish shift of the ECB will be mostly felt by the front part of the yield curve. However, it's undeniable that the whole German yield curve willsettle above 0% as the ECB gets ready to normalize its monetary policy. 

Italian government bonds’ honeymoon is over.

The celebrations for the re-election of President Mattarella were short-lived. After a modest tightening of the BTP-Bund spread on Monday, the spread resumed rising yesterday. It shows that the performance of Italian government bonds does not depend entirely on the national political situation. At this moment, they are more vulnerable to central banks’ monetary policies.

Because BTPS carry a higher beta than peers, Italian sovereigns will suffer the most as volatility in rates markets increases. Therefore, we remain constructive on our view that the BTPS-Bund spread will widen to 160bps before resuming its tightening decennial trend.