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Fixed Income Quarterly – Eurozone: Looking ahead to ECB action

Consumer and business confidence appear to be taking a turn for the better in the eurozone as inflation falls and expectations for interest rate cuts rise. These could help the economy avoid a significant recession.  

Developments in the labour market and wage growth will have important implications for core inflation. Despite lacklustre growth and signs of a cooling labour market, wage growth has been strong, especially in the services sector. Forward-looking wage trackers signal that wage pressures have remained high and recent wage deals have corroborated that narrative.

Tight credit standards and weak loan demand reflect the transmission of the European Central Bank’s (ECB) tight monetary policy, rendering it a force that would likely keep economic activity constrained over the coming quarters. Indeed, companies and consumers have pointed to the level of interest rates as the main factor dampening demand.

Banks as well as other companies do not perceive an easing in financing conditions to be around the corner. This perception will be key to track: greater confidence that the ECB’s tightening cycle has ended would affect the expectations of banks, households and companies and could herald  a pickup in activity and hence growth.

Having raised interest rates over 10 consecutive meetings, the ECB has been holding the line that it should not lower its guard on inflation just yet. However, there have been recent hints that a dovish pivot may come, including downward revisions of inflation forecasts. Still, the ECB will likely want more information that inflation is turning down before easing its policy stance.

Comments from ECB members have recently become more dovish, with the change in ECB Board member Isabel Schnabel’s tone particularly notable as she welcomed an easing of inflation pressures. Schnabel is seen as the most influential voice in the hawkish camp, and her dovish comments have led investors to ratchet up the likelihood of ECB rate cuts this year.

Bond market – A strong fourth quarter

The euro sovereign bond market saw strong performance over the fourth quarter: 10-year Bund yields fell sharply amid softening economic activity and a faster-than-expected slowdown in inflation. This appeared to convince investors that the ECB would not raise the deposit rate beyond the current 4.00% and that September’s policy rate hike was the last in the cycle. 

The faster-than-expected decline in inflation weighed on euro breakeven rates, but expectations for rate cuts helped ‘peripheral’ sovereign bonds to outperform.

At the beginning of the fourth quarter, our view was that downside risks to the eurozone economy had increased as the once-buoyant services sector started to lose momentum and as a combination of cyclical and structural factors held back the manufacturing sector. 

With sovereign bond issuance needs from eurozone economies at historical highs, and the ECB on the path to further trim its balance sheet, concerns over higher term premiums would likely remain on investor radars. As such, we maintained curve steepeners in the portfolio to reflect a weaker growth outlook and concerns over rising term premiums.

Overall, we saw gains coming from our short euro breakeven inflation position and the curve steepeners. The underweight in Italy versus core countries and the underweight in 2-year nominal yields held back performance.

Our base line scenario – protracted downturn

While inflation has started to normalise, and the effects of monetary tightening are close to a peak, business and consumer sentiment has yet to recover fully. Companies are still concerned about their competitiveness as they have not yet found a sustainable source of cheap energy, while workers are still looking for wage increases to compensate for the loss of purchasing power driven by the hefty inflation of the past two years.

We expect the lagged impacts from the substantial rate rises to continue to weigh on the economy. Fiscal aid in the form of energy subsidies will be rolled back, although public investment expenditures will likely be protected with contributions from the Next Generation European Union (EU) funds and other EU budgets.

Robust nominal wage growth and fading inflation means real wages are now recovering. This should support consumption. Overall, there are still buffers in the eurozone that should help to manage weak foreign demand and tight credit conditions, and prevent outright recession, but protracted stagnation remains our baseline scenario. 

We expect core inflation to reach 2% by mid-2024. That said, we are cognizant that the ‘last mile’ of the ECB’s efforts to reduce inflation to 2% may not be smooth. 

As said, government measures to partly shield consumers from higher energy and food prices will be phased out such that energy taxes, VAT on food, and regulated electricity prices will rise. Recent disruptions to the shipping routes around the Suez Canal could push up the costs of imported goods and energy more meaningfully should geopolitical tensions escalate.

Falling inflation and weak growth should allow the ECB to pivot to rate cuts in 2024, likely starting in June. We expect the ECB to prefer to incorporate the outcomes of the wage negotiations in the spring in their assessment before kicking off a rate cutting cycle.

Portfolio positioning

We favour curve steepeners as we believe front-dated bond yields should outperform as the ECB edges closer to a rate cutting cycle. At the same time, long-dated yields remain vulnerable to a potential rise in term premiums amid still high sovereign bond issuance needs and as central bank bond buying ends.

In duration, we maintain a modest underweight in the two-year sector as we see room for front-dated yields to reprice slightly higher given the recent recovery in consumer and business sentiment surveys and the aggressive ECB rate cutting now reflected in market prices.

We expect 10-year Bund yields to trade between 2.0% to 2.5% in the near term and maintain a short bias in longer-dated breakeven rates on the view that tight credit conditions and slower growth should bode poorly for this segment. There is a risk of the ECB tightening for longer than needed, while easing inflation should cause inflation hedging demand to recede.


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