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Bonds get wake-up call from ECB warning


(Bloomberg) — European bondholders are facing the fact that this year’s heavy losses could linger even further into 2023.

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The worst year for the region’s bonds is ending with one of the fiercest sell-offs in months, after central banks simultaneously warned investors that interest rates were headed higher. expected. With traders already betting on another 130 basis point rally, compared with just half a point from the Federal Reserve, a new wave of selling looks set to emerge.

European Central Bank policymakers have made clear their determination to stamp out double-digit inflation in recent days, after long regarded as one of the world’s most dovish countries. . It was a shock to traders who poured money into the region’s battered assets with a false sense of security against expected signs that inflation was peaking.

“It’s a lot less controversial now to not just see European yields reset higher in absolute terms,” ​​said Ralf Preusser, head of global interest rate strategy at Bank of America. but we also see the European interest rate market underperforming the US significantly throughout 2023.” Stock.

The market was quick to react to the ECB’s warnings. Since Thursday’s meeting, investors have increased their bets for the highest odds to 3.30%. Yields on Italy’s 10-year bond – one of the most sensitive to tighter financial conditions – rose more than 40 basis points, creating the worst weekly sell-off since June. . German two-year bonds hit 2.50%, the highest level since 2008.

At the heart of the ECB’s stance on higher interest rates is the forecast for inflation, which has been revised up significantly. Consumer prices fell for the first time in a year and a half last month, falling to 10.1 percent last month from a record 10.6%, but are still forecast to average 3.4% next year. 2024 and 2.3% in 2025. The ECB’s target is 2%.

Too much?

It was a blow to the region’s government debt managers, who are still reeling from what is almost certainly the worst year on record. The Bloomberg index that tracks the sector has fallen 15.5% this year, the biggest drop on record to date.

The ECB’s uncompromising tone reinforced recommendations from Deutsche Bank AG and UBS Group AG to position European yields rising closer to their US counterparts. Just this past week, the spread between the 10-year German and US yields narrowed the most since March 2020.

Despite the strong revaluation to date, there is some skepticism that the ECB will be able to deliver on the promised level of tightening. That’s because rising borrowing costs risk pushing the region into a deeper recession, exacerbating the damage already caused by the energy crisis arising from Russia’s invasion of Ukraine. .

Guillermo Felices, global investment strategist at PGIM Fixed Income, said higher interest rates at a time of rising government bond issuance could “trigger a market revolt”. In turn, that conflict could trigger a swift exit by the ECB, potentially damaging its credibility.

Global recession looms in 2023 as central banks continue to grow

Of particular concern is the impact on Italy, the center of the latest bond routine. The country is one of Europe’s most indebted economies and a big beneficiary of the ECB’s bond-buying stimulus and extremely loose monetary policy.

The country’s interest premium relative to Germany — a gauge of regional risk — recorded its biggest weekly gain since the early days of the pandemic in April 2020.

Mohit Kumar, interest rate strategist at Jefferies International, said: “Monetary policy that is too aggressive runs the risk of creating a more severe recession and widening periphery differentials, which will increase risks. fragmentation”. It’s possible that ECB President Christine Lagarde was “a bit overzealous” in her attempt to convey another half-point rally in February.

bond surplus

However, there are plenty of other reasons to remain cautious about the performance of the bond market early next year.

The ECB has laid out a much-anticipated plan to shrink huge debts in times of crisis, removing a pillar of support from the market sooner than some had envisioned. According to Board member Francois Villeroy de Galhau, the central bank will allow 15 billion euros of bonds to mature each month from March, potentially accelerating that pace from the end of the second quarter.

That would increase the net supply of bonds as governments ramp up issuance to fund programs to protect their citizens from punitive energy prices and the cost-of-living crisis. Bank of America’s Preusser said that the lack of supply pressure in the US is another reason to favor Treasuries over European debt.

BNP Paribas SA strategists are expecting the net supply of European government bonds to reach €228 billion ($242 billion) in the first quarter and reach €557 billion for the whole of 2023, assuming a re-introduction process. Investment ends in July or September at the latest.

“What the market didn’t understand and value, is that fiscal easing as energy prices rise requires tighter monetary policy. Inflation is 10%. Axel Botte, global strategist at Ostrum Asset Management, said deposit rates have many ways to change. “It’s a wake-up call when the hawks have the upper hand.”

–With support from James Hirai.

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