Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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Whatever the ECB decides, the answer lies with short-term sovereigns
Althea Spinozzi
Head of Fixed Income Strategy
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%.
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%
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