Head of Fixed Income Strategy
Summary: The message from the European Central Bank is clear: expect status quo until the German election. European sovereigns will chase the trend of US Treasuries until fall. Then, higher fiscal spending and better European integration will inevitably push Bund yields into positive territory. Expect risk premia to squash across European government bonds in the long term as we head towards a better European monetary union.
The market quickly categorized yesterday’s European Central Bank meeting as a "non-event". Yet, I believe that at the press conference, Lagarde transpired a crucial point: the ECB won't change its accommodative stance at least until Autumn. Guess what's coming in the fall? The German elections.
The recovery fund is not the only European program that the German constitutional court challenges. The pandemic emergency purchase program (PEPP) is facing a legal challenge questioning its legality entirely. Although this claim is overshadowed by news concerning delays in the Recovery Fund, the legal challenge against the PEPP it's macroeconomically more important. The PEPP has funded European countries' fiscal stimulus packages amid the Covid-19 pandemic. Without it, financing conditions would inevitably tighten, posing an insurmountable threat to the euro system.
The German elections bring about two critical topics: fiscal spending and European integration. We believe that whatever coalition will be formed will lead to either more fiscal expenditure or better European integration, or a mix of the two. The austerity scenario remains a threat, but it is improbable. A CDU/CSU/Green coalition will favour public investment and European integration. It will lead to a better monetary union and squashing risk premia among European sovereigns in the long run.
US Treasuries will dictate sentiment in European sovereigns until the fall
US Treasuries will fill the vacuum that the German election brings to the European sovereign space until fall. We have recently seen 10-year US Treasury yields retracing to levels observed more than a month ago. Yet, we believe that as the macroeconomic backdrop strengthens as the economy reopens, we will see yields pointing higher.
Since mid-march, 10-year Treasury yields have been falling together with their relative strength index (RSI). If they descent to test their support line at 1.50%, and the RSI falls below 40, they may fall even further. However, we exclude yields will break below 1.40% unless there is an endogenous event that forces the market into safe-haven mode. On the other hand, if they break above 1.60% they will enter into bullish territory, leading them quickly to 2%.
The direction of US Treasuries is even more evident in bond futures. Below you find a chart of the continuous contract of 10-year US Treasury futures. It tells us that it will be hard for Treasury futures to break above the 133 level (around 1.40%), making a downward trend even more probable.
Another selloff in US Treasuries will provoke European yields to soar because despite the ECB being committed to keeping financing conditions stable, the correlation between US and European sovereigns continues to be positive. We believe that Bund yields are likely to move higher to test their resistance line at -0.20%, and if they break that level, they will most likely rise to 0.15%. There is also the chance that yields break below their ascending trendline to fall as low as -0.40%; however, the rally will be short-lived.
Prepare for positive bund yields in the long-term
An increase in public investment will most likely contribute to a realignment of sovereign bond yields in the euro area. Indeed, suppose the German government will be looking to increase spending. In that case, it will need to issue more Bunds, hence contributing to higher yields. Bund yields are negative because the European Central bank has bought more than the new debt issued by the country. The scarcity of collateral is a substantial macroeconomic threat because, without more Bunds, the ECB has limited power to intervene when financing conditions tighten.
At the same time, a German government looking for comprehensive European integration will also contribute to higher bund yields. As soon as Mario Draghi entered Italian politics, he highlighted the desperate need for a common EU budget, which will enable greater fiscal spending at the European level. A common EU budget would reduce economic disparities among EU countries, contributing to a tightening of sovereign spreads versus the safe-haven Bund. Risk perception of European sovereigns will level out, provoking divesting Bunds and investing in other European government bonds.
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
