Macro: Sandcastle economics
Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.
Head of Fixed Income Strategy
Despite the ECB's preparations to cut rates, european sovereign bonds continue to decline. This can be attributed to the surge in commodity prices sparked by potential escalations in Middle East conflicts, hinting at sustained or even increased inflation in the latter half of the year.
Inflation plays a crucial role in bond performance. If it remains high, the chances of a bond bull rally are slim, as central banks would struggle to implement aggressive rate cuts. Expectations for Fed rate cuts in 2024 have dwindled from nearly six to less than two, while in Europe, they have decreased from almost seven to three.
Despite expectations that the ECB would be more aggressive in cutting interest rates than the Federal Reserve, this divergence hasn't halted the rise in Bund yields. Starting the year at 2%, ten-year yields have climbed to nearly 2.5%, showing an upward trend that could push them to test resistance at 2.5% and potentially reach 2.75% if breached.
Assuming a one-year holding period, yields would need to exceed 2.8% to result in a loss. Considering the potential for persistent inflation or economic recovery, the upside of such a position in the event of a market downturn or disinflationary trends cannot be ignored. For instance, if 10-year Bund yields were to drop from 2.46% to 1.46%, the position would yield an 11% upside.
While 10-year Bunds have declined by approximately 2% since the start of the year, Italian BTPs have remained stable. This outperformance can be attributed to the fact that Italian BTPs offer the highest yields among European sovereign bonds.
This high yield makes Italian BTPs attractive as a "safe haven" asset if inflation persists, as they provide a stronger hedge against inflation. Additionally, they would benefit from their correlation with the Bunds in the event of heightened tensions in the Middle East. Recent years have shown that higher yielding fixed-income securities, such as junk bonds, have demonstrated resilience in the face of high inflation.
Considering a one-year holding period, Italian BTPs offer an appealing risk-reward profile:
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