European Central Bank (ECB) president Christine Lagarde’s recent blog flagged the imminent end of negative interest rates in the eurozone—a move to help tackle high inflation. Markets may now be overestimating future euro-area growth and inflation, creating opportunities for active bond investors.
ECB Continues the Journey to Policy Normalization
The ECB had been tightening policy since December last year, winding down its bond-buying activities by ending net asset purchases under the pandemic emergency purchase programme (PEPP) and announcing an expected end date for net purchases under the asset purchase programme (APP).
Lagarde’s latest comments marked another important step on the path to normalizing policy:
“Based on the current outlook, the ECB is likely to be in a position to exit negative rates by the end of the third quarter.”
This would end six years of ultra-loose monetary policy, with euro-area rates held below zero to try and stimulate economic growth and return inflation to its targeted 2% level.
The day of the announcement, the euro rose by 1.1% against the dollar and the German 10-year bond yield by 0.06% to above 1%. Based on interest-rate futures, investors’ expectations now indicate modestly positive euro-area rates by September (Display, above). Subsequent remarks from the ECB’s chief economist Philip Lane, referring to prospective 25 basis point rate hikes in July and September as “a benchmark pace,” reinforced market expectations.
Weakening Growth May Reduce Hawkish Resolve
Lagarde stressed future policy moves would be incremental, based on “gradualism, optionality and flexibility”—keeping the ECB’s options open as economic variables change. The market consensus expects euro-area economies to remain resilient—a view supported by robust nonconsumer survey data.
By contrast, we believe euro-area growth will weaken in the second half of the year, as the rebound from COVID-19 falls away and external shocks come to bear. If we’re correct, the ECB’s stance in future will likely be less hawkish than the market expects.
Positioning for a Slowdown
Government bonds for euro-area periphery countries seem more attractive now that spreads have widened (10-year Italian bonds yield almost 2% more than German Bunds). Peripheral countries’ underperformance reflects fears of sustained higher rates—which in our view may not be realized.
We think adding interest-rate risk is more likely to be rewarded in Europe, assuming growth and inflation won’t rise materially. Inflation pressures should ease faster in Europe than the US: wage demands are lower in Europe and the pre-pandemic inflation background was structurally weaker. In fact, markets are already signaling relatively lower euro-area inflation. When the ECB last met, German 10-year inflation breakevens (the yield difference between nominal and index-linked bonds) were around 3% versus 2.21% as of May 30. USD breakevens have fallen less, from 3% to 2.65%.
With robust fundamentals, comparable yields and better credit quality, European corporate bonds appear more attractive than those in the US. This holds true from very high quality covered bonds through investment-grade credit and down to BB/B-rated high yield. Signals from our quantitative tools reinforce that fundamental view, suggesting higher excess returns in euro credits than US dollar credits.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.