European bond enthusiasts are placing their bets on a significant deceleration in inflation to bolster their conviction that an economic downturn is looming. Money managers at institutions like J.P. Morgan Private Bank, BlackRock Inc., and Baring Investment Services Ltd. are making a stronger case for purchasing European bonds as the economic outlook weakens.
Their attention is laser-focused on the upcoming inflation report scheduled for Tuesday, which is anticipated to reveal a drop in price growth to 3.1%, the lowest level in over two years, according to economists surveyed by Bloomberg.The European Central Bank (ECB) added to the optimism of fixed-income investors by suspending its 14-month tightening cycle just last week. Speculation is already mounting regarding how soon the ECB might have to implement rate cuts.”With each incoming data release, the case for the ECB to become more dovish is gaining strength,” said Samuel Zief, Head of Global FX Strategy at J.P. Morgan Private Bank.
Given the current landscape, there is a compelling backdrop to consider European bonds across the yield curve. The notion that the ECB’s next move could be anything other than a cut “looks hard to believe,” he added.Private-sector activity in the region delivered discouraging results last week, suggesting that Europe might be teetering on the edge of a recession, particularly with Germany standing out due to sluggish Chinese export demand. All these factors contribute to the dwindling chances of another ECB interest rate hike, according to money market traders. They are currently pricing in a mere 2 basis points of additional increases, equating to a probability of less than 10% for further tightening. In fact, money markets are foreseeing the first full quarter-point cut by June and a total of approximately 80 basis points in cuts by the end of 2024.
Viraj Patel, a senior strategist at Vanda Research, has pointed out that the return of core inflation to levels below 3% in the first quarter of 2024 can no longer be ruled out. The core metric, which excludes more volatile elements like energy and food, is anticipated to reach 4.2% this week according to a Bloomberg survey. Adjusting to this idea could trigger “the next phase of dovish ECB price discovery,” Patel suggested.Patel also believes that the yield spread between two-year U.S. Treasuries and equivalent German bonds could rise significantly beyond the current levels of around 200 basis points if earlier and more substantial ECB rate cuts are factored into the equation.
Meanwhile, the spread in 10-year yields has also experienced a notable increase and last week reached its highest level since early 2020.Notably, ECB President Christine Lagarde’s concerns about Europe’s economic prospects stand in stark contrast to robust U.S. data, where third-quarter growth was recorded at 4.9% – the fastest pace since 2021. Despite this, traders still see a one-in-three chance of another interest rate hike by the Federal Reserve by January.Brian Mangwiro, a fund manager at Baring, highlighted the growing divergence in economic growth between Europe and the United States, supporting the case for overweight allocations in European sovereign bonds versus the U.S. “Weakening European growth and inflation outlook provides a better anchor for bond investors,” he explained.Nevertheless, it’s important to remain cautious, as progress on inflation may be tested if the conflict in the Middle East escalates, potentially driving energy prices higher.
Additionally, Lagarde reiterated last week that it’s too early to consider rate cuts. It’s worth noting that one-year inflation swaps increased nearly 50 basis points in the two weeks following the October 7 Hamas attack on Israel, although that movement has since moderated.Konstantin Veit, portfolio manager at Pacific Investment Management Co, suggests that markets may be overly optimistic about the proximity of rate cuts. The spillover from the weakness in the U.S. Treasury market, a major driver behind the recent rise in European yields, remains a significant headwind.Ann-Katrin Petersen, a senior investment strategist at the BlackRock Investment Institute, believes that the threshold for an ECB rate cut is higher than for another interest rate hike. Despite this, Lagarde’s efforts to downplay the possibility of tighter balance sheet policies, such as reducing bond holdings at an accelerated pace, enhance the attractiveness of high-quality government debt. “As market pricing reflects ECB policy rates staying high for longer, even as growth deteriorates, we are tactically overweight longer-term euro area government bonds,” she noted.
