"The yield curve could remain inverted for a while longer and begin to steepen when prospects for rate cuts start appearing."
Head of Fixed Income and Fund Manager of the GIS Euro Bond range
- Over 25 years of experience
- AAA rated by Citywire1
A dovish hike
The ECB’s rate hike of 25 bps on 14 September was seen by the markets as a ‘dovish hike’. Weak activity data and the downward revision of the ECB’s growth and inflation projections were the key reasons behind the longer discussion involved.
The hike proceeded given headline inflation is still seen as “too high for too long” with some indicators, such as oil and gas prices, having increased recently. The ECB implied that current rate levels are sufficient to bring inflation back to target over time, and President Lagarde implied that the focus has now shifted towards maintaining present rate levels.
Have we reached the peak of the ECB hiking cycle?
It’s hard to see how inflation could rise given the current macroeconomic picture. European PMIs have deteriorated significantly since June, and GDP expanded by only 0.1% in Q2, lower than initial estimates of 0.3%. However, the new ECB forecasts still assume the initial estimate of 0.3% QoQ growth and they expect stagnation rather than slowing growth in Q3 this year, driven by higher consumption on the back of receding inflation and a decent labour market.
However, these projections may be too optimistic. The disinflationary trend is essentially confirmed, with a downward adjustment (-0.1%) in expectations for core inflation over the next two years. In the coming months, it will be important to monitor energy prices – the main inflation risk factor – and see whether wages consolidate.
Currently, markets are pricing in only a slim chance of a rate increase in Q4. If a stagnant economy and disinflation are confirmed in the last quarter of the year, the market’s focus will be on how long the ECB can keep rates unchanged. At the moment, this seems to be a discussion for the second half of 2024, but considering the uncertainty of the macroeconomic scenario and, above all, the difficulty of predicting the economic effects of the rate hike cycle, one should not discount the possibility of an earlier than expected reversal of the monetary cycle.
The ECB lifted its key rates by another 25 bps, bringing the deposit rate to 4.00% and the repo rate to 4.50%.
We may have reached the peak of the hiking cycle, given macro indicators point to a stagnant or slowing economy for the coming quarters, with receding inflation.
The portfolios have shifted to a neutral duration exposure, but moved from the long end of the curve to the medium-short end, to maximise yields while mitigating against potential market volatility.
Higher for longer
In a “higher for longer” rates scenario, yields should continue to move within the range observed in recent months. The yield curve could remain inverted for a while longer and begin to steepen when prospects for rate cuts start appearing.
Adding duration to investment portfolios could be a useful diversification strategy in the event of a risk-off environment or increased volatility, which usually benefit sovereign bonds. Inverted yield curves typically allow investors to maximize yields without taking on too much interest rate risk in their portfolios.
In our funds: Shifting to the short-end
In my view, it’s not yet time to take a strong position on rates, but we are starting to reduce the defensive stance that has characterized our strategy since early 2023. We continue to manage duration tactically with a moderate overweight. This is driven by our expectation that, in the coming months, ten-year Euro bond yields will continue to move within the range observed in the past weeks until the next downward rate move, especially on the short end.
We have also shifted exposure from the long end of the curve to the medium-short end, to maximise yields while mitigating against potential market volatility arising from slowing economic growth.
Turning to geographical exposure, we are tactically rebalancing our allocation to peripheral debt from Italy and Greece. We continue to have a positive view on peripheral European debt, particularly as the ECB has no plans for the moment to modify the reinvestment program for PEPP-related securities.
However, we opted to reduce the strong overweight on Italian BTPs over the summer, as the risk of slower economic growth in Italy could increase their volatility, especially during budget discussions. That said, we are ready to re-enter if spreads return to their yearly highs. We have offset this reduction with a higher exposure to Spanish government bonds, where we were underweight, to benefit from increased diversification and the attractive carry offered. Finally, we remain overweight on European Union issuances, as they offer a good risk-reward profile.2
"It’s not yet time to take a strong position on rates"
1.50% to 1.00%
ECB growth forecast cut for 20243
Average YTM 1-3 Year ICE BofA Euro Government Bonds Index3
Average YTM 5-10 Year ICE BofA Euro Government Bonds Index3
1 The investment team is subject to change. Source of award Citywire. A rating is drawn for illustration only and is subject to change. For more information about the rating (methodology, universe taken) please refer to the following link: https://citywire.com/americas/manager/mauro-valle/d5145. 2 There is no guarantee that an investment objective will be achieved or that a return on capital will be obtained 3 Source: Bloomberg as at the 18 September 2023.
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