Head of Fixed Income Strategy
Summary: The tightening of the BTP/Bund spread, European corporate spreads, and swap spreads below historical average levels are not putting pressure on the ECB to cut rates nor to steer away from the unwinding of its balance sheet. As bond markets have already recalibrated bets on rate cuts for this year, European yield curves are exposed to bear-steepening risk for the rest of the quarter while the ECB remains on hold for longer.
Bond markets are telling us that the ECB has room to stick with its plan to cut rates gradually and to continue to unwind its balance sheet. That may mean that now that markets have recalibrated the expected pace of cuts for this year from seven to four, yield curves might bear-steepen for the rest of the quarter.
Even if disinflationary trends pick up in the year's second quarter, allowing the ECB to cut rates, investors should still beware of taking too much duration risk, as previously discussed. Indeed, the unwinding of the ECB balance sheet is likely to continue. At the same time, reinvestments under the Pandemic Emergency Purchase Programme (PEPP) will begin to be capped in the year's second half.
Below is a list of factors allowing the ECB to keep calm and cut later.
First, the BTP/Bund trades around 150 basis points, 15bp below its ten-year average. That is important because the widening of the BTP/Bund spread beyond 200bps has been an undesired event in the past, which provoked the intervention of the ECB. A much higher cost of funding in the periphery versus Germany is both a monetary policy and political headache. The ECB wouldn't necessarily tighten monetary conditions more in the periphery than in Germany. Secondly, anti-EU sentiment might grow if financing conditions diverge too much in the periphery from core Europe.
The good news is that at the current BTP/Bund spread level, the central bank has plenty of room to wait to declare victory over inflation and to continue to reduce its balance sheet gradually.
Following last quarter's bond rally, the European investment grade (IG) and high yield (HY) bond spreads fell below their ten-year average. The Itraxx Europe and Crossover indexes are credit default swap indexes that measure the performance of the respective on-the-run iTraxx CDS contracts. They can also be seen as the spread that IG or HY companies need to pay over their benchmark to issue debt. As these spreads tighten, they reflect a decrease in the market's risk perception for the underlying instruments. Tightening CDS spreads while policy rates remain the highest the ECB has ever implemented, implicitly gives the ECB the green light to continue with its balance sheet reductions.
The picture changes if we look at the nominal yield that European IG and HY bonds are currently paying. Excluding the 2022-2023 highs, European IG corporate bonds at 3.6% pay the highest yield since 2011 and more than double the average from 2010 until today. At the same time, the cost of funding for HY bonds has only risen by 23% above their fourteen-year average, paying a yield of 5.85% versus an average of 4.75%. Although, in absolute terms, these yield levels should be enough to put pressure on companies looking to refinance their debt, the good news is that corporates in Europe were able to extend their debt profile during the COVID pandemic. The maturity of European IG and HY corporate debt will pick up only in the first quarter of 2025, allowing the ECB to cut rates slowly while continuing to unwind its balance sheet.
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