Of Eleftheria Kourtali
Central banks are closing the taps on liquidity and monetary stimulus in a time of stubbornly high inflation, pushing up government bond yields and borrowing costs, especially in the Eurozone, as the European Central Bank has also entered the final stretch. its first interest rate hike. The yield on the 10-year German bond is hovering around 1%, when just a few months ago it was moving in deep negative levels, dragging the spreads – especially of the peripheral countries – to multi-year highs, increasing the risk of fragmentation and debt service costs. which is the “key” to its viability.
The market is now well aware that central banks are focusing solely on tackling high inflation, “sacrificing” growth, which has heightened fears of stagnant inflation and recession. Goldman Sachs is already giving the US a 35% chance of recession, while, according to Citi, Eurozone GDP growth is likely to be close to zero on average over the next three quarters, despite strong winds of opening the economy after the pandemic, while the risk of a technical recession seems high in the summer.
Analysts have long since announced the end of cheap lending and believe that bond yields will move further higher, following the cycle of tightening monetary policy. The only thing that could put a brake on the spreads would be the effective implementation of the PEPP reinvestment program, as well as a new backstop from the ECB, however, the level that would cause this mobilization remains unknown and analysts estimate that the markets will test the “endurance” of Frankfurt.
More aggressive interest rate hikes are not ruled out
The governor of the Dutch central bank, Klaas Not, said a few days ago that the ECB prefers to raise the policy rate by 25 basis points. in July, but larger increases of 50 bp. should not be ruled out if “data in the coming months suggest that inflation is expanding further or accelerating”.
The speeches of the members of the Governing Council of the ECB have rapidly become more aggressive in recent weeks, to the extent that the forecasts for the course of interest rates that were considered extreme at the bank meeting a few weeks ago have now been widely adopted.
Citi estimates that other board members may also consider raising interest rates by 50 basis points and setting an equally low bar for them, such as Not, who is one of the ECB’s hawks.
And Finland’s central bank governor Olli Rehn said the ECB needs to move quickly out of negative interest rates to prevent a change in inflation expectations. For his part, Mario Senteno, also a member of the board. The ECB, which has already estimated that interest rates will rise in July, stressed that the normalization of monetary policy after a long period of very low interest rates is necessary and must be done in a sustainable way. “Low interest rates are a reality that will end soon and economic agents need to take this into account,” he added. On the other side of the Atlantic, Jerome Powell said last week that the Fed would raise interest rates as needed to reduce inflation.
The market climate is clearly reflected in the new Bank of America survey of fund managers, which showed that aggressive central banks are considered the biggest risk to markets (by 31% of funds), with the second is the global recession (27%), the third is inflation (18%) and the fourth is the Russia-Ukraine conflict (10%). Fears of stagnant inflation have risen to their highest level since 2008, while fears of a recession have outweighed the risks of inflation and war in Ukraine.
“The ECB can not ignore market fragmentation”
The combination of market expectations for a faster and stronger cycle of ECB interest rate hikes, a sharp slowdown in growth and rising government bond yields has brought debt sustainability issues back to investors’ radars, as Pictet points out. The good news is that most countries have taken advantage of years of extremely low interest rates to increase the duration of their outstanding debt, making them less sensitive to temporarily rising interest rates. However, a persistent interest rate shock has the potential to put the debt ratio of countries in the region, such as Italy, on an upward trajectory until 2030, he said.
Excluding a further and persistent increase in Italian bond yields by 200 basis points, Pictet estimates that Italy’s debt-to-GDP ratio should either stabilize (if yields increase by an additional 100 basis points) or, in its baseline scenario, to fall further to 140% by 2030. “We stand by our expectations for a reduction in the 10-year Italian spread against the Bund from 195 bp today to 160 bp by the end of the year,” he added. .
However, he points out, the key to this view of limiting spreads is its expectation that the ECB will move less aggressively in terms of interest rates than the market expects, as it is constrained by both weaker growth and expects the euro area inflation to moderate slightly in the second half of the year. However, in the meantime, the 10-year Italian spread could continue to hover around 200 bp. by the end of the summer, with market participants likely to test the ECB’s determination to use the flexibility built into PEPP reinvestment.
Therefore, the ECB could well announce its readiness to use this flexibility in its forthcoming meetings if the region’s government bond spreads relative to the Bund widen further. However, ruling out a sharp and wide increase in spreads, the ECB is not expected to announce a new QE-type tool. “The bar is very high as the ECB re-focuses on its main mission: fighting inflation,” Pictet concludes.
The risk of expanding regional spreads has increased
While Capital Economics’s baseline scenario remains that the Eurozone regional spreads will increase slightly from now until the end of 2022, it believes that the risk of a significant increase has increased.
The spreads of the 10-year bonds of the region have declined slightly in recent days, however, this marks only a break from their general trend for this year, which is clearly upward, as he emphasizes.
The ECB sounds increasingly aggressive in its intention to normalize its policy, which it now wants to move forward faster than initially thought. Many officials, including President Christine Lagarde, have made it clear in recent speeches that both the end of asset purchases and the first rate hike may come in July.
Capital Economics continues to estimate that regional spreads will end in 2022 a little higher than they are now. He believes that the Eurozone economy will remain stagnant for the next six months and that Germany and Italy will experience recession. However, it still expects the ECB to pursue a tougher policy than investors expect. In recent announcements, ECB executives have focused on the need to tackle high inflation rather than the weakness of economic activity. And various indicators suggest that inflation expectations and underlying inflationary pressures in the Eurozone, including wage pressures, have risen recently. This will strengthen the ECB ‘s determination to tighten its policy.
However, according to Capital Economics, it would not be a surprise if the spreads of the region increased significantly more than expected, especially in the short term. Its current forecasts are based on the assumption that the increase in spreads will be limited by the belief that the ECB will intervene in the bond market if the spreads increase too sharply. However, recent comments by ECB officials suggest that the bank will only agree to the details of a new QE program if it is urgently needed to avoid “fragmentation”, rather than committing to a backstop as a precaution. This increases the risk of a temporary increase in spreads.
In addition, while it remains unclear at what level of spreads ECB officials would feel comfortable in the medium term, they may be willing to accept further expansion. Indeed, officials have not been overly concerned about the rise in regional spreads this year, although they are in many cases moving to higher levels since 2015 – albeit lower than the peak reached during some periods of political turmoil and the pandemic. In any case, Capital Economics believes that the Eurozone bond market is vulnerable to a sharp and violent sell-off in the near future.
The only way is the further increase of the yields
Global bond markets remain under strong pressure due to market pricing for more interest rate hikes, according to Goldman Sachs, which is revising its performance forecasts. Thus, it expects that in 2022 the yield on the 10-year US bond will increase to 3.3%, from 2.7% previously forecast, the yield on the 10-year German bond to 1.25%, from 0.75%, and the 10-year British bond to 2.25%, from 1.95%.
For most economies, inflation has been surprisingly high and well above central banks’ targets. While Goldman Sachs economists in many areas believe that inflation has peaked or will peak soon and in some countries, such as the US and the UK, expect a significant slowdown in growth, inflation remains well above the target, leading to a continuation of interest rate increases. However, with markets already pricing higher policy rates, bond yields are expected to continue to move higher.
In addition to inflation and its impact on domestic monetary policy, another factor that could play a role in the bond market is the situation in the Eurozone and Japan. The negative interest rate policies pursued by central banks in both areas, combined with persistently low inflation over the past decade, have led to low, and in many cases negative, nominal yields and overseas returns. With the eurozone ready to emerge from the era of negative interest rates and the risk of Japan making changes to its policy of controlling the yield curve, the factors that kept global bond yields lower have been reversed, the US bank said.
In the Eurozone, the change in the ECB’s communication is particularly important for bonds, as it has now adopted a more worrying tone about its impact on inflation. This has peaked in recent weeks, with the vast majority of officials pointing to an increase in interest rates in July. The ECB thus gave a decisive “signal” for a rapid normalization of its policy, despite signs of a slowdown and a significant widening of spreads, with the market pricing three to four interest rate hikes for the rest of the year. For this reason, Goldman estimates that bond yields in the Eurozone will move higher in the near future.