Talking Heads – Quel scénario pour les obligations d’État de la zone euro ?

This is an audio transcript of the Talking Heads podcast episode: What’s next for eurozone government bonds? 

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing eurozone government bonds and interest rates. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Alberto Talero, Portfolio Manager. Welcome, Alberto, and thanks for joining me.  

Alberto Talero: Hi, Daniel. Thank you very much for having me. 

DM: One of the surprises this year has been more how strong US growth has been rather than how weak growth has been in the eurozone, which took a bigger hit from the energy shock. The US has benefited from several trillion dollars in stimulus and the Inflation Reduction Act, and one consequence is US Treasury yields at around 5%. The eurozone hasn’t benefited [from such initiatives]; European companies are investing more in the US to take advantage of some of the tax breaks, and not in Europe. On top of that, geopolitical concerns are geographically closer to Europe than the US. In light of all that, what is your view on the macroeconomic situation and outlook in the eurozone? 

AT: Recent eurozone data for retail sales and industrial production point clearly towards a deterioration of economic activity, but if we look at recently published GDP numbers, we see that we have to differentiate between blocs in the eurozone.  

Countries that are more dependent on Germany and France, such as Austria or Italy, are close to a technical recession. Other countries less dependent on Germany are showing strong domestic demand, strong spending, which is surprising to the upside.  

Since 2022, I have been looking at the microeconomic level such as company margins. For me, a recession in the absence of external shocks or a banking crisis is really just symbolic of the domino effect of companies failing to pay their bills. In fact, thanks to economies reopening [since Covid], companies have made so much money that their margins have been boosted to all-time highs and hence they have a larger cushion to weather adverse economic shocks. That means this time around they are feeling less restricted by tight monetary policy.  

What I expect for the coming quarters is quite sluggish activity because the full impact of monetary policy tightening is yet to be felt in the economy.  

DM: You say Germany and countries with greater economic links with Germany are flirting with recession. At the same time, inflation is still a big worry, certainly for the European Central Bank. How do you see ECB monetary policy evolving as it tries to balance keeping growth as strong as possible while trying to get inflation back down to target? 

AT: The ECB is focused 100% on bringing inflation down to 2%, that is really its only mandate. Recent inflation data has been showing it slowing by more than the market and the ECB expected, so I believe the ECB has finished hiking rates in this cycle.  

However, we need to focus on what the ECB will do in the coming quarters. What will be interesting to see is the ECB’s inflation forecast in December, which will include inflation for 2025 and 2026.  

In the forecast published in September, the ECB predicted inflation for 2025 at 2.1%. So, if we take into account the latest data, I believe the 2025 forecast should be revised to the downside. As to what it could forecast for 2026, it could see forward inflation at 2% or even 1.9%. That could give the market some indication of whether the ECB could be cutting rates next year.  

I believe the ECB could cut rates in the second half of next year, not because growth will be weak, but because the central bank will realise it no longer needs restrictive rates to bring inflation down to the target of 2% in the medium term. That is the first part of the story.  

The second part is what’s happening with the ECB’s balance sheet. ECB members have been vocal in saying that they should ramp up the slowdown of reinvestment under their bond buying programmes. I believe that’s coming into the pipeline and could be announced in the first quarter of 2024.  

In fact, I think the ECB should announce that slowdown of investments as soon as possible as it will likely not want to be reducing the balance sheet at the same time as it is cutting rates. That would be difficult to justify for markets.  

Overall, I think the balance sheet will continue to be reduced and that will continue to put pressure on the longer end of the eurozone government bond curve.  

DM: If we look at the US, we see 10-year Treasury yields hitting 5%, at least partly due to strong growth from fiscal stimulus. There are also worries about fiscal sustainability – people see that the US has a large budget deficit. Debt levels and the cost of financing that debt are both higher. In Europe, we can all recall past debt sustainability problems for some countries. Should we be worried about that? For example, what do you think when you look at Italy? 

AT: Italy has been in the recent spotlight on the back of several factors that have triggered a widening of the spreads between 10-year yields for Italian bonds versus German Bunds.  

The first factor is the deterioration of the macroeconomic backdrop for Italy, once the government has removed the fiscal support it announced to tackle the energy crisis, and with the government announcing a fiscal deficit larger than the market expected. In 2023, the fiscal deficit is 5.3% and for 2024, 4.3% – both larger than the market was expecting.  

Importantly, the government appears unwilling to address the fiscal situation and consolidate, which is also part of why markets are worried about Italian government bonds. The domestic support for Italian government bonds we saw through the first half of the year is no longer there.  

These factors explain the widening of [Italian government bond] spreads to 200 basis points versus German Bunds. But I think that all those factors are already priced in, and in the absence of significant news, these spreads should trade in a range. Various rating agencies look as if they are considering revising their rating for Italy downwards. In the current status quo, I think the spreads should range between 180 and 220 basis points.  

My main concern is the supply wave we will likely have in 2024. That could be the main challenge for Italian government bonds, especially when the government shows no willingness to reduce the fiscal deficit meaningfully.  

DM: Thinking about eurozone government bond issuance in the year ahead and investor demand for those bonds, how do you see that balance and what might be the implications for interest rates? 

AT: We are going from a world of quantitative easing to one of quantitative tightening. The main buyers of government bonds – central banks – will no longer be there, which means the ECB for the European government bond market.  

The easy part of the equation is supply, which should continue to be quite heavy into 2024, at levels similar to that in 2023. Taking out redemptions plus quantitative tightening by the ECB, there should be around EUR 600 billion of net supply in 2024.  

There are more problems on the other side of the equation, the demand side, which gives rise to my concerns. There are various types of investors that could be buying bonds.  

First, we have insurers and pension funds. They have been suffering outflows throughout 2023 because of clients reallocating their assets from insurance products to money market products. While they have cash to cover those outflows, they don’t have the appetite to buy duration.  

If we look at asset managers, they are already lean in long duration and the level of cash is low. For example, hedge funds trade derivatives, so they are not big contributors in terms of cash flows into the market.  

There are two other players, the first being official institutions (central banks) that are moving to quantitative tightening, so they are no longer buying many bonds. And there are domestic banks, which have enough cash to absorb supply into 2024. However, they [tend to] swap their purchases to the primary market, meaning that they do not contribute strongly to duration when buying bonds.  

So, we need to look at players that could be buying bonds into 2024, for example, the retail market – individual investors. 2023 saw retail investors increasing their allocation to fixed income via exchange-traded funds (ETFs). And the retail market is also highly active, with retail bonds being issued by countries such as Italy and Belgium with great success.  

I believe we will still have demand from the retail segment in 2024. The question is how much, and will it be enough to soak up this wave of supply? I believe it may not be, and that we will need other buyers.  

We could have a hard-landing scenario, or another significant crisis, with investors in multi-asset portfolios then selling risky assets to buy fixed income. That could be one of the sources of demand in 2024. 

DM: Alberto, thank you very much for joining me. 

AT: Thank you very much. It’s been a pleasure.