Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Head of Fixed Income Strategy
Summary:
- A revision on the downside of the ECB’s staff projections will fuel expectations of upcoming aggressive interest rate hikes.
- The ECB will likely focus on labor market tightness as a reason to keep rates high for longer.
- Monetary policies in the U.S. will become increasingly more important for the ECB in the future as the euro currency is at risk of a sharp devaluation if the ECB turns dovish too early.
- The market will look for any mention of the PEPP program.
- With bond futures pricing five rate cuts in 2024 starting in March, the ECB has plenty of room to push against such expectations amid easier financial conditions and stable sovereign spreads in the upcoming weeks.
This week's European Central Bank monetary policy meeting will be a focus for markets together with the FOMC and Bank of England.
Bond futures are pricing a 50% chance that the ECB will begin cutting rates in March next year, delivering overall five rate cuts throughout 2024. That means the ECB is expected to move towards rate cuts before the Fed and the BOE. This notion is reinforced by three consecutive months of inflation figures that are surprising on the downside, falling to 2.4% YoY, the lowest in more than two years. On top of it, the eurozone economy has slowed significantly, with Germany and the Netherlands in a recession.
We have heard several ECB officials turning slightly dovish for a few weeks, citing the need to cut interest rates next year to avoid further economic damage. The most recent change of heart comes from a prominent hawk: Isabel Schnabel, who, until last month, insisted that rate hikes need to continue to be an option. In a recent speech, Schnabel recognized that further rate hikes are unlikely and opened the door to rate cuts in the mid of 2024.
Although Lagarde will maintain a hawkish bias, updates to the ECB's staff projections might speak louder. As of September, these projections forecasted headline inflation to fall to 3.2% this year and 2.1% in 2024, while real GDP was to end 2023 at 0.7% and 2024 at 1%. As both GDP and inflation have so far surprised on the downside, it’s safe to expect a lower revision for both data this year and the next. The lower the projections, the more markets will anticipate aggressive interest rate cuts.
A tight labor market will remain concerning for the ECB when looking at inflationary pressures in the eurozone. Unemployment remains at 6.5%, the lowest on record. Despite wage pressures starting to ease, they remain above 5% (compensation per employee), too high to ensure a return to the ECB inflation target of 2%. That’s why policymakers might not be rushing to dovish rhetoric this week and will instead want to stay on hold for longer, putting under scrutiny next year's rate cuts currently priced markets.
It’s also essential to remember that whatever happens in the U.S. will also be relevant for monetary policy decisions in the old continent going forward. An even stronger labor market in the U.S. suggests that the upcoming Fed’s aggressive rate cuts are unlikely. If expectations of rate cuts in the U.S. are pushed out to 2025, we can expect rate cuts to be pushed further into the future in the old continent as well. If the ECB cuts rates too early, it risks a sharp devaluation of the euro currency, risking to increase inflation.
Therefore, Lagarde is more likely to push back on early rate cuts rather than tilting dovish. Reinvestments under PEPP (Pandemic Emergency Purchase Portfolio), which were expected to remain untouched until the end of 2024, might be used to reject the idea that a cutting cycle is approaching. A couple of weeks ago, Lagarde mentioned that the PEPP program would need to be re-examined in the “not too distant future."
The PEPP facility has proven to be a valuable tool for the central bank because it enables it to skew bond purchases towards government bonds of those countries in which sovereign spreads are widening excessively compared to Bunds. Therefore, if PEPP is discussed at this meeting, it will not only provide a floor in terms of how early pre-emptive interest rate cuts may come, but it might also come as a blow to the periphery.
Suppose policies to end reinvestment under the PEPP are implemented as early as January 2024. In that case, a pre-emptive cut is unlikely to happen at the next monetary policy meeting in March. That should be enough for markets to push the probability of the first rate cut to April or June.
Yet, we believe that the BTP-Bund spread remains a critical measure for ECB monetary policies. It tightened significantly in the past couple of months, falling to 180 basis points from 206 basis points in October. Together with the fact that according to the Bloomberg Economics euro financial conditions index, economic conditions have eased to levels seen before summer, it remains improbable that the ECB will feel the urge to cut rates anytime soon. Its concern would rather be how to continue to maintain a hawkish bias without markets' front-running rate cuts, as happened in November. As the BTP-Bund spread widens above 200bps and heads towards 250bps, that would be a sign that the central bank becomes more uncomfortable about tight monetary policies and that easing might be approaching.
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research 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. To the extent that any content is construed as investment research, you must note and accept that the 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 under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)