German Bonds a No-Go Zone as ECB Seen Keeping Hawkish Stance

(Bloomberg) — Investors are shying away from German bonds, saying the European Central Bank won’t be derailed from an aggressive interest-rate increase next week — even by a wave of economic data and a potentially dovish Federal Reserve decision beforehand.

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A euro-zone inflation print and a survey on European lending activity on Tuesday, as well as a rate decision from the Fed on Wednesday, all need digesting before ECB Chief Christine Lagarde delivers her verdict on Thursday.

Given persistent price pressures, managers from Abrdn Investments to Newton Investment Management are bracing for the possibility of a fourth 50 basis-point hike in a row. As the prospect of tighter European policy drives investors to US Treasuries, their yield gap with German bonds is the narrowest in almost a decade.

“If you asked me whether I’d like to buy a 10-year US Treasury or a 10-year Bund, I’d take the Treasury certainly,” said Jon Day, bond portfolio manager at Newton. For Day to return to German bonds, “yields would have to become more rational in terms of what’s priced, or inflation pressures would need to fall away,” he said. “The ECB has more work to do.”

For now, money markets are pricing a 25 basis point hike. With annual core inflation in the euro area expected to hold near a record high this month, and conviction growing that the euro zone may avoid a recession, those wagers may prove optimistic, according to James Athey, investment director at Abrdn.

European benchmark bonds are turning into a no-go zone.

“Along with Japan, the euro area is the only place I’m still underweight duration,” Athey said, referring to bonds like government debt which are more sensitive to interest-rate changes. “The US and European outlooks have flipped — last year looked much worse for Europe and now it’s the other way round. I’m more comfortable owning US duration where we’re positioning for lower rates.”

Statistics on Friday showed the euro zone avoided a recession earlier this year despite rampant inflation. While a separate print confirmed price pressures climbed in France and Spain this month, they unexpectedly eased in Germany. That kind of mixed bag hints at the scope for next week’s data to blur the picture and exacerbate divisions among ECB policymakers. Strategists at Nomura Holdings Inc. switched their prediction for a 50 basis point increase to a 25 basis point hike after the reports.

The inflation numbers for the euro zone as a whole are due on Tuesday, the same day a highly anticipated banking survey lands. Strong signs lenders are tightening credit after 350 basis points of rate hikes since July could curb the need for an aggressive hike. The industry is still recovering from the takeover of Credit Suisse Group AG by UBS Group AG last month.

Steepening Trades

“We’re not as confident as the market is that rates are going to come straight back down again,” Newton’s Day said. “The market thinks rates are going to go up, plateau for a few months and then start coming down. We have more sympathy for the plateauing part, but it’s the pace they will come down when inflation is still so high that we don’t see as a central case.”

Orla Garvey, portfolio manager at Federated Hermes, expects signs inflation is subsiding around mid-year. That would be a signal to increase so called curve-steepening trades, in which investors buy shorter-dated bonds while selling longer-dated ones, in anticipation of an end to the ECB’s tightening cycle. Until then, she’s staying long Treasuries.

“Until you see that real, meaningful slowdown it’s really hard to get on that steepening trade,” she said. “That’s the kind of uncertainty that everyone’s experiencing this year.”

The prospect that euro zone rates will keep rising after US rates peak helped to lift the euro to its highest level in more than a year against the dollar this week. But given that the outlook for rates in the euro zone and the US remains so dependent on future inflation prints, there’s little conviction for the common currency to go much higher, according to Andreas Koenig, global head of FX at Amundi.

“You wait until something comes into the market, some new argument, and then there’s movement and you jump on it — a bit like jumping on a bus for a few stops, and then jumping off,” he said. “It feels like people are just waiting for this bus, but it’s just not coming.”

Next Week:

UK Nationwide House price data due on Tuesday is expected to show the house-price correction continuing
The Bank of England releases its Decision Maker Panel survey on Thursday. Another elevated inflation expectations reading would only stoke Monetary Policy Committee concerns around inflation persistence
Germany, France and Spain are expected to sell bonds totaling €21.7 billion ($23.9 billion), according to Citigroup Inc
The UK DMO will offer bonds maturing in 2025 and the BOE will sell long-end debt

–With assistance from Alice Gledhill.