Her Eleftherias Kourtali
Recently, the strong sell-off suffered by the bonds of the euro area and especially the region – with the yield of the Greek 10-year reaching even 3.8% – has eased, but the volatility is strong in the market due to the aggressive stance of the ECB and the certain increase in interest rates in the summer. According to analysts at Goldman Sachs, Citi and Capital Economics, the pressures are by no means a thing of the past and a new sell-off and expansion of the spreads is expected as the ECB’s policy normalization continues, while the activation of a new tool against fragmentation is not considered possible and so the market is expected to test the tolerance and resilience of the central bank.
Eurozone bond yields have been volatile, however, at Goldman Sachs have not yet peaked. The slowdown in growth or fears of a recession and the growing need to tighten the ECB’s policy are the factors that have put significant pressure on bonds in recent times, and the US Bank believes that yields will rise further, especially to end of the year.
According to Goldman, the ECB is lagging behind other G10 central banks in the normalization process and the rhetoric of its officials is becoming more aggressive and this will continue until the June meeting, at which the ECB is likely to lay the groundwork. for its first rate hike in more than a decade. As nominal inflation has not yet peaked (economists expect it to peak at ~ 9% in October) and incoming data suggest the European labor market is tightening, Goldman Sachs continues to expect yields on its 10-year bonds Germany will rise to 1.25% at the end of the year, dragging bond yields across the eurozone.
And at Citigroup The further rise in yields and spreads of eurozone bonds is one way.
Christine Lagarde argued that the market has been pricing the tightening of ECB policy over the past six months. This process has led to a 90 basis point widening in the Italian 10-year spread since the ECB meeting in October 2021. However, the spread smoothing has not yet been completed, according to Citi.
A short-term catalyst for further enlargement could be the lack of progress on the anti-fragmentation tool at the ECB meeting in June, which is being pressed by the “pigeons” of the Board, which, as Panetta reiterated last week, de Guidos confirmed, has not been discussed in detail so far. This is in line with the basic scenario of the American bank. Even if the ECB is surprised by this, it expects that any relief rally in the bonds will be short-lived, as the threshold for activating such a tool is likely to be vague and high. Another catalyst for further expansion of spreads could be the supply rate, which has so far been limited by rising borrowing costs and rising government revenues due to inflation.
“The ECB’s aggressive stance increases the risk of further spread of regional spreads,” she said. Capital Economics.
More specifically, according to the house, although the recent aggressive turn of the ECB did not have a big impact on the spreads of the eurozone periphery, the risk of normalization of the ECB policy to trigger a strong sell-off in the regional bond markets remains high.
Following a steady rise for most of this year, the region’s 10-year bond spreads against 10-year German bonds have stabilized in recent weeks. This may come as a surprise, given that the ECB – whose plans to normalize monetary policy were probably one of the main drivers of higher spreads in 2022 – is sounding increasingly aggressive. For example, last week Christine Lagarde confirmed that the deposit rate will rise from -0.5% now to at least 0.0%, if not a little more, by the end of September. This leaves the door open for the ECB to start the tightening cycle even with an increase in interest rates by 50 basis points in July (as Capital Economics expects). With inflationary pressures still strong and policymakers wanting to pull the deposit rate off the ground, the ECB is likely to raise interest rates by 50 basis points in July and by 125 basis points overall this year.
The recent calm in regional bond markets reflects two factors, according to Capital Economics. First, while investors’ expectations for the policy rate in the near future have shifted upwards, those for its “final” value in this cycle have declined. This was also the case with interest rate expectations in some other developed markets. This probably reflects concerns that economic growth will slow, forcing central banks in general to raise interest rates by less than previously expected.
Second, since they came under pressure earlier in the year, risk assets have generally stabilized. The basic scenario of CE remains that the spreads of the region will end in 2022 higher than they are now. This is partly because he believes that the ECB will focus more on tackling high inflation than on weakening economic activity and raising the deposit rate to a maximum of 1.5% by mid-2023. It also expects risk assets will generally be under a little more pressure over the next year as global economic growth slows.
“The above supports our prediction that the spread of 10-year Italian government bonds will move to 200 basis points by the end of 2022 with the aggressive turn of the ECB increasing the risk of launching spreads,” notes Capital Economics. Can Lagarde, like other officials, emphasize that the ECB will ensure that policy is evenly distributed across jurisdictions, maintaining flexibility in its approach to policy smoothing and, if necessary, using “new means” (obviously a new program)? asset market). However, there has been no clarity about the characteristics of such a new tool or the conditions under which it will be developed. The ECB has also not shown much concern about the rise in spreads so far this year, although it is now quite high by previous standards. This could be interpreted as an indication that policymakers are willing to tolerate fairly high levels of spreads if their increases are gradual.
“All of this increases the likelihood, in our view, that investors will continue to test the extent of the ECB ‘s willingness to support the regional bond market,” Capital Economics concludes.
Source: Capital
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