Euro-area bond yields have tumbled in recent weeks, amid galloping expectations that the European Central Bank will make a seismic about-turn and slash interest rates next year.
A 25-basis point cut in official rates is almost fully priced in for as soon as March, with close to 150 basis points anticipated for 2024 in futures contracts. The market is getting way, way ahead of itself, risking disappointment for investors who have chased bond prices higher.
While Germany sets the pace in European fixed income, bunds are just matching an equivalent yield decline for Treasuries. US 10-year yields have dropped dramatically since reaching 5 per cent in mid-October, a peak that triggered a global shift back into fixed income after the entire asset class had been friendless since the start of April. The dollar has also weakened since early November which has added fuel to the fire behind equities and bonds in the fourth quarter.
Germany’s 10-year bund yield has fallen 80 basis points since peaking just below 3 per cent in early October, bringing it back to where it was in the spring. Italian bond levels, which tend to be more volatile, have fallen even further, dropping below 4 per cent from a brief spell in excess of 5 per cent. The repricing has been comprehensive, with the drop in euro yield curves surprisingly uniform across maturities.
The bullish case for euro-denominated fixed income has been boosted by respected ECB policymaker Isabel Schnabel drawing a line under the “we could hike again” platitudes that some central bankers persist with. Her recent concession that the inflation improvement means the central bank is unlikely to increase its current 4 per cent deposit rate again is welcome common sense. But this signifies a pause – not a 180-degree handbrake turn.
A shift to lowering borrowing costs next year is logical – the weakness of the euro-area economy is increasingly evident – and consumer price measures are falling faster than almost every market estimates. But the pace and scale of the expected rate cuts is out of step with likely reality. The latest Bloomberg survey of economists shows that market pricing remains ahead of analysts’ expectations, with the consensus forecast not seeing the first reduction until June.
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As ever, there are some outliers. Deutsche Bank analysts made a big revision last week, hastening their call for the first ECB rate cut to April rather than September – and flagging a non-negligible chance that it comes in March. They expect two 50 basis-point cuts at successive meetings, with further moves later in the year bringing the deposit rate down to 2.5 per cent.
Goldman Sachs analysts also cut their ECB forecast last week, but expect a more tranquil path with a quarter-point cut at every meeting from April dropping the official rate to 2.25 per cent by early 2025. The good news is that a potential economic crisis resulting from keeping rates too high for too long seems likely to be averted, but such a swift correction in monetary policy foretells trouble of a different type – recession.
ECB president Christine Lagarde is unlikely to sanction an imminent policy change at this week’s governing council meeting on Thursday. She’ll want to buy time to see how the economy pans out, while keeping the more hawkish members at bay. But this week sees a quarterly economic forecast review – so if there’s to be a change in direction, it would be best to flag it either now, or when the forecasts are revised again in March.
Some difficult decisions lie ahead as the euro area economy is slipping into contraction. Headline inflation has retraced the bulk of its gains, falling faster than expected to 2.4 per cent in November having peaked at 10.6 per cent in October 2022. It’s likely to tick back up in December due to base effects from last year’s energy subsidies falling out. Core inflation ought to continue its steady decline, but at 3.6 per cent it’s still well above the ECB’s 2 per cent target. Meantime, the latest euro-area purchasing managers’ surveys showed some stability after a bout of significant weakness, notably in manufacturing.
The hawks on the governing council will need a lot of persuading that the 18-month, 450 basis-point hiking cycle needs a swift reversal. Many will want to see how the spring wage negotiation round goes before even thinking about sanctioning a relaxation in their monetary stance. The main topic at this week’s meeting is expected to be whether to increase the pace of quantitative tightening by no longer reinvesting maturing bonds accumulated via the pandemic purchase programme. This decision may be delayed until next year; retaining maximum flexibility on defending relative spread differentials between the euro-area bond markets ought to remain a priority.
But the balance of risks is evidently shifting for the ECB. Inflation paranoia is subsiding, with the new flashpoint being how swiftly unemployment might rise. Due to more restrictive employment laws, the European Union’s labour market changes more slowly than either the US or UK. Both of those are showing signs of weakness, which ought to be a warning to the euro zone.
Waiting for either inflation to slow all the way back to target or joblessness to surge risks a major policy mistake. So rate cuts are surely coming to the bloc – just not at the pace that the market is currently expecting. – Bloomberg
