Whatever the ECB decides, the answer lies with short-term sovereigns Whatever the ECB decides, the answer lies with short-term sovereigns Whatever the ECB decides, the answer lies with short-term sovereigns

Whatever the ECB decides, the answer lies with short-term sovereigns

Althea Spinozzi

Senior Fixed Income Strategist

Summary:  Long-term yields are poised to rise further amid hawkish central banks, quantitative tightening, and the BOJ looking to exit the yield curve control. We expect 10-year Bund yields to test March highs at 2.76% in the upcoming weeks despite Germany being in a recession. At the same time, the German yield curve is likely to bull-steepen as investors position in the front end amid expectations of the hiking cycle to end. Within this context, short-term sovereigns offer a win-win solution. An investor buying 2-year Schatz today at 3.15% would still be in the green if rates were to rise by another 300bps throughout the next year, offering a decade-high yield and flexibility amid an uncertain environment.

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%.

Source: Bloomberg.

Short-term sovereigns offer an appealing risk-return ratio

Although we expect long-term yields to continue to rise, European sovereigns remain attractive.

If you buy 10-year Bunds (DE000BU2Z015) at 2.65% today and hold it for one year:

- If the yield goes to 3.2%, you would lose -1.9%
- If the yield goes to 2%, you would gain +7.5%

If you buy a 2-year Schatz (DE000BU22023) at 3.15% today and hold it for one year:

- If the yield goes to 4.15%, you would still gain 2.18%
- If the yield goes to 2.15%, you would gain 4.15%

Yet, we favor the front part of the yield curve, which enables one to maximize returns while limiting duration. Indeed, if inflation surges again, central banks on both sides of the Atlantic might need to continue to tighten the economy despite a recession undermining their economies, putting upward pressure on long-term rates.

Looking at European sovereigns, Italian BTPS attract one's attention as they offer the highest yield in the euro bloc. They also provide an appealing risk-reward ratio:

If you buy 10-year Italian BTPS (IT0005544082) at 4.45% today and hold them for one year:

- If the yield goes to 4.95%, you would lose -2.95%
- If the yield goes to 3.95%, you would gain +12.11%

If you buy 2-year Italian BTPS (IT0005557084) at 3.86% today and hold them for one year:

- If the yield goes to 4.86%, you would still gain 2.87%
- If the yield goes to 2.86%, you would gain 4.78%

The Saxo 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 is not intended to and does not change or expand on this. 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 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 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 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 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 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-hk/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo or its affiliates.

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK Limited (“Saxo”) is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo holds a Type 1 Regulated Activity (Dealing in Securities); Type 2 Regulated Activity (Dealing in Futures Contract); Type 3 Regulated Activity (Leveraged Foreign Exchange Trading); Type 4 Regulated Activity (Advising on Securities) and Type 9 Regulated Activity (Asset Management) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products may result in your losses exceeding your initial deposits. Saxo does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo does not take into account an individual’s needs, objectives or financial situation. Please click here to view the relevant risk disclosure statements.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-hk/about-us/awards.

The information or the products and services referred to on this site may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and services offered on this website are not directed at, or intended for distribution to or use by, any person or entity residing in the United States and Japan. Please click here to view our full disclaimer.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc. Android is a trademark of Google Inc.