Head of Fixed Income Strategy
Summary: European sovereign spreads continue to widen following last week’s ECB’s hawkish tilt, putting the ECB in a difficult spot. This week, speeches from Lagarde and other policymakers will be in the spotlight as the market advances interest rate hikes expectations. However, as the BTPS-Bund spread approaches 200bps, the central bank might become more cautious on an early tightening agenda. In the US, the CPI numbers for January will be a focus together with the 3-year, 10-year, and 30-year US Treasuries auctions starting from tomorrow. As the Federal Reserve approaches the end of tapering, the question is whether appetite for government bonds will remain strong despite a bear bond market.
Following ECB Knot’s commentary during the weekend, the market is quickly advancing interest rate hikes in the euro area for this year. Investors now expect an interest rate hike of 25bps by September. The market reaction gives us a glimpse of what 2022 will look like with a hawkish ECB, which could terminate QE early (around July, as BofA’s research recently indicates) and hikes rates in September. It doesn’t promise anything good for the periphery. An aggressive ECB takes support away from those countries that need it the most for their recovery, provoking a fast tightening of financial conditions in Southern Europe compared to the north. This is an outcome that the central bank definitively wants to avoid not to revive a political crisis in the euro area.
However, the French election is coming in April. With inflation running at the highest ever for the Eurozone, there is the chance that Macron will not be re-elected in favor of euro-skeptics, which also threatens the real existence of the European Union. Within this complex context, the ECB is given the delicate job to take a monetary decision in March, which might sign the bloc's destiny.
Economically, remaining dovish is not an option, as the euro will weaken, weighing on energy prices, thus bringing more inflation.
Therefore, it’s improbable that the central bank will turn dovish, but it is also true that its hawkishness must have a limit. We see the ECB hawkishness limit drawn by the BTPS-Bund spread as it reaches 200bps. Since the end of the European sovereign crisis in 2013, the spread between the two countries broke and sustained above this level only twice: during the 2018 Italian election and the 2020 Covid pandemic. A BTPS-Bund spread above 200bps has been associated with distress levels in the past. It is likely to happen the same this time around, except that the ECB will not prioritize it until the French election is over in April.
This week bond investors are better to focus on ECB’s speakers, starting today with Lagarde speaking at the hearing of the European Parliament’s Economic and Affair Committee. We will also hear from De Cos, Villeroy, Guindos, and Lane throughout the week. The European Commission's economic forecasts released on Thursday are also in focus, which will probably see a revision in growth and inflation forecasts.
Amid a hawkish BOE and ECB last week, US Treasury yields resumed their rise, with 10-year yields breaking above 1.88% for the first time since January 2020. The market is waiting impatiently for the CPI numbers on Thursday, expected to come out at 7.3%, the highest since 1981. The question is whether the market will advance interest rate hikes and price a 50bps rate hike in March, on the back of it contributing to another selloff in US Treasuries.
Data concerning the trade balance will also be in the spotlight as an increase of the trade deficit requires foreign investors to step up their purchases of US assets while the Federal Reserve is ending bond purchases and more buyers are needed to support the trade budget. Therefore, bidding metrics during the next three days' 2-year, 10-year, and 30-year US Treasuries auction will be in focus. During the auction of the same tenors in January, we have seen indirect bidders step up purchases of all issuance except for the 10-year Bonds as yields were rising. Now that yields are way higher and 10-year eur-hedged US Treasuries offer 100bps over the Bund, it's safe to expect demand to be sustained. However, will investors buy government bonds carrying a high duration as we enter a bond bear market?
Monday, February the 7th
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