Bonds Get Wake-Up Call From ECB Warning

(Bloomberg) — European bondholders are coming to terms with the fact that this year’s devastating losses may have further to run in 2023.

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The worst-ever year for the region’s bonds is ending with one of the most brutal sell-offs in months, after a chorus of central bankers warned investors that interest rates will rise more than expected. With traders already betting on another 130 basis points of hikes, versus barely a half-point increase from the Federal Reserve, a fresh wave of selling looks to be in store.

European Central Bank policy makers have made their determination to quash double-digit inflation abundantly clear in recent days, after having long been regarded as one of the world’s most dovish. That’s a shock for traders who had piled into the region’s battered assets with a false sense of security given tentative signs inflation was peaking.

“It’s a lot less controversial now to not only see European yields reset higher in absolute terms, but we also see European rates markets underperform the US very meaningfully throughout all of 2023,” said Ralf Preusser, global head of rates strategy at Bank of America Securities.

The market has been quick to respond to ECB warnings. Since its Thursday meeting, investors have raised their wagers for a peak rate to 3.30%. The yield on 10-year Italian bonds — among the most sensitive to tighter financial conditions — has added more than 40 basis points, making for the worst weekly selloff since June. Germany’s two-year note touched 2.50%, its highest since 2008.

At the heart of the ECB’s stance for higher rates was its forecasts for inflation, revised up significantly. Consumer prices posted the first slowdown in 1 1/2 years last month, declining to 10.1% last month from a record 10.6%, but are still seen averaging 3.4% in 2024 and 2.3% in 2025. The ECB’s target is 2%.

Too Much?

It’s a blow for the managers of the region’s government debt, still reeling from what’s almost certain to be the worst year on record. A Bloomberg index tracking the sector is down 15.5% this year, by far its biggest loss on record.

The ECB’s uncompromising tone has cemented recommendations from Deutsche Bank AG and UBS Group AG to position for European yields to rise closer toward US peers. Already in the past week, the spread between German and US 10-year yields has narrowed by the most since March 2020.

Despite the sharp repricing so far, there is some cynicism that the ECB will be able to deliver the level of tightening promised. That’s because soaring borrowing costs threaten to tip the region into a deeper recession, compounding the damage already wreaked by the energy crisis arising from Russia’s invasion of Ukraine.

Higher interest rates at a time of increased government bond issuance could “trigger a market revolt,” said Guillermo Felices, global investment strategist at PGIM Fixed Income. “That clash, in turn, could trigger a swift retreat by the ECB, potentially damaging its credibility.”

Global Recession Looms in 2023 as Central Banks Keep Hiking

Of particular concern is the impact on Italy, at the center of the latest bond rout. The nation is one of Europe’s most indebted economies and has been a major beneficiary of the ECB’s bond-buying stimulus and ultra-loose monetary policy.

The nation’s yield premium over Germany — a gauge of risk in the region — posted its biggest weekly jump since the early days of the pandemic in April 2020.

“Overly aggressive monetary policy risks engineering a sharper recession and widening of peripheral spreads, which will raise fragmentation risks,” said Mohit Kumar, a rates strategist at Jefferies International. It’s possible ECB President Christine Lagarde “went a bit overboard” in efforts to convey another half-point hike in February.

Bond Glut

Still, there are plenty of other reasons to remain cautious over the bond market’s performance in the early part of next year.

The ECB set out a much-anticipated plan to shrink its vast crisis-era debt holdings, removing a pillar of support from the market sooner than some had envisioned. The central bank will allow €15 billion of bonds a month to mature from March, potentially increasing that pace from the end of the second quarter, according to Governing Council member Francois Villeroy de Galhau.

That will inflate the net supply of bonds just as governments ramp up issuance to finance programs to protect their citizens from punitive energy prices and a cost-of-living crisis. That supply pressure, absent in the US, is another reason to favor Treasuries over European debt, said Bank of America’s Preusser.

BNP Paribas SA strategists are expecting net European government bond supply to hit €228 billion ($242 billion) in the first quarter and as much as €557 billion across 2023 as a whole, assuming reinvestments end in July or September at the latest.

“What the market had failed to understand and price in, is that fiscal loosening in face of high energy prices requires tighter monetary policy. Inflation is 10%. Deposit rates have ways to go,” said Axel Botte, a global strategist at Ostrum Asset Management. “It is a wake-up call with hawks getting the upper hand.”

–With assistance from James Hirai.

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Source: https://finance.yahoo.com/news/bonds-wake-call-ecb-warning-080000288.html