With the ECB due to downgrade growth projections for this year and the next and increasing inflation forecasts for 2024, the case of stagflation becomes clearer. The big question is whether the ECB will continue to hike despite a recession in Germany and the Netherlands. Since the most prominent hawks come from these countries, a hawkish pause at this week's ECB rate decision makes political sense. Indeed, the ECB can enforce other tightening measures, such as ending reinvestments under the PEPP, without spooking markets.
A pause or a hike won't change the fact that Bund yields are poised to rise
The closer we get to the end of the hiking cycle, the more investors will position for the yield curve to bull-steepen. Therefore, in case of a pause, despite Lagarde maintaining a hawkish tone, yields will likely drop across maturities, particularly in the front end of the yield curve.
Yet, we do not expect the rally to last for long because selling pressure in the long part of the yield curve remains:
- US Treasury yields are still uptrending. Bunds are tightly correlated to US Treasuries, so if we see yields continuing to rise in the US, it's safe to expect the same to happen in Europe, too.
- The BOJ is looking to exit yield curve control (YCC). That means that Japanese investors will sell securities abroad to buy at home.
- Quantitative tightening (QT) adds upward pressure to yields. In July, the ECB ended reinvestments of redemptions under the Asset Purchase Program (APP) facility.
- As investors position for the yield curve to steepen, they will buy the front end and sell the long part of the yield curve adding to upward pressure to long-term yields.
Hence, we expect Bund yields to continue to rise to test resistance at 2.76%.