In the recent month, the bond market has sustained its rally, witnessing a substantial decline in European yields. The 10-year Bund yields are presently trading 30-40 basis points below the levels observed at the beginning of the year. Notably, market sentiment is currently inclined towards the notion that the European Central Bank (ECB) will implement a substantial policy rate cut of 150 basis points in the upcoming year, a notable shift from the previous expectation of a 65-basis-point decline just a few months ago.
While the perceived fall in yields is deemed by some as excessive, there is acknowledgment that both US and European data have brought the possibility of rate cuts closer to realization. Inflation is on a downward trajectory in both the Eurozone and the US, with price pressures easing even in deeply entrenched components of consumer price indices, such as service prices. The diminishing underlying inflation holds significance for central banks, evident in its impact on the interest rate meetings in December, where discussions on further rate hikes seemingly dissipated entirely.
The easing signs of inflationary pressure in developed economies have influenced the rhetoric of central bankers who, until recently, were open to further interest rate hikes. A notable example in the past month is the shift in stance from Isabel Schnabel, a key member of the ECB’s Governing Council, who effectively removed the prospect of more rate hikes when stating, ‘When the facts change, I change my mind.’
However, the question remains: have the facts changed enough in just a couple of months to justify such a significant repricing of interest rate expectations in the market? Skepticism arises as the sources of uncertainty in the inflation outlook persist.
Despite economic weakness this year, labor markets in both the US and Europe have proven resilient. US economic data, in particular, remains surprisingly robust in the face of higher interest rates. While the global economy is expected to grow below trend in the coming year, a full impact of monetary tightening leading to a crisis is not anticipated.
As the drop in long yields appears to be behind us, the prevailing view is that market developments have outpaced reality. The roughly 150 basis points worth of rate cuts priced for next year suggests a more pessimistic economic environment than currently foreseen. While Europe is experiencing weak growth signals, a major crisis is not anticipated.
European consumers stand to benefit from rising real incomes, driven by accelerating nominal wage growth and slowing inflation. This is expected to enhance purchasing power in 2024, supporting the economy alongside high employment and generally elevated savings.
Forecasts indicate the ECB is likely to implement three 25-basis-point policy rate cuts next year, commencing in June – roughly half of the market’s current pricing. The ECB’s cautious message at its December meeting, balancing risks with the expected resilient economic outlook, increases the likelihood of earlier rate cuts. Regardless of the timing, rate cuts are likely to be initiated to ensure a soft landing rather than in response to a major economic downturn.
Anticipating sensitivity in the long end of the yield curve to any repricing of the rate-cutting cycle, concerns are linked to market dynamics that contributed to a significant rise in long yields in the autumn. While US debt challenges persist, overall government debt issuance in Europe is expected to remain high in 2024. If markets reprice policy rates higher while absorbing an increased supply of bonds, conditions may be ripe for greater volatility in bond markets.
The term premium on long bonds is considered particularly sensitive to this scenario. Forecasts indicate 10-year Bund yields at 2.35% on a 12-month horizon, compared to the current level of 2%. Meanwhile, expectations for US 10-year Treasury yields suggest an increase from the current 3.9% to 4.20%. Slightly lower rates and yields at the short end of the swap/government curves are expected, driven by the anticipation of the initial round of rate cuts in both the US (100 basis points) and the Eurozone (75 basis points) by the end of 2024.
