The spiral of European Fixed Income – Not Yet

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The ECB is likely to accelerate its pace of rate hikes, while the anti-fragmentation tool will eventually need to be built on conditionalities, namely much needed economic reform in the European periphery. This suggests some prudence on Eurozone sovereign long-dated fixed income. Over time though, as the economy slows and with it eventually inflation, the market is likely to turn ever more towards longer-dated fixed income. Eventually, it should also move towards High Yield, typically shorter-duration, in the usual spiral of risk taking.

ECB forced to accelerate the pace of rate hikes

With Eurozone inflation of 8.1% and the EURUSD close to parity, the ECB has lost some credibility evidenced by a two-year break-even inflation of 5% (German TIPS) and increasing grumbling amongst households. The snowball effect of ever larger groups clamoring for better compensation is steadily spreading. As a consequence, the ECB has been slowly turning more hawkish, far more slowly than many other advanced economy central banks. It hopes to win the battle of time when falling global demand leads eventually to a sharp fall in energy prices, a very risky strategy. Citigroup for example has estimated oil prices at 65 dollars by year-end in the case of a global recession. Copper is already crashing as the global economy rapidly slows down, though lockdowns in China are also a significant factor.

ECB rates expectations (Eurozone ESTR futures curve)

Source: Nordea Investment Funds S.A. and Bloomberg

So what is the ECB doing?

It has already flagged rate hikes on July 21st and September 22nd to bring interest rates away from negative territory (see Graph above), but monetary policy remains very loose as real interest rates remain very negative. In essence, it is still great to issue debt if your company can grow in line with inflation. Expectations of a 50 basis point rate hike in July remain on the fringe of the ECB council but over time becomes ever more probable. What the ECB is likely to do is to extend its forward guidance by signaling a more rapid set of rate hikes culminating slightly above the currently expected terminal rate of 2%. The ECB’s economic growth forecast of 2.8% for this year, when we are likely headed for natural gas rationing, is likely overly optimistic but close to private forecasters’ 2.7%. That suggests that these forecasts will be revised down and with it, the overly optimistic earnings forecasts.

Defragmentation tool

As the ECB turns more hawkish, it becomes questionable whether Italy or Greece can live with such higher interest rates. There is a technical definition that defines this known as the Domar Debt Stability condition: The debt explodes if the national cake does not grow fast enough relative to the cost of paying the debt. The consequence was recently a significant upward pressure on the Italian and Greek sovereign curves until the ECB introduced the concept of an anti-fragmentation tool.

While the first iteration of this tool or set of tools should be presented in July, the open question from Bundesbank Nagel (Germany) is conditionality, namely necessary economic reform in exchange for lower interest rates. You simply can’t legally and politically give a blank check to the periphery. The last result of this debate was the conditional Outright Monetary Transaction (OMT) facility, which was never used. Indeed, the current process of reinvesting maturing principals and coupons into the European periphery is unlikely to continue without a legal challenge. It is equivalent to selling core cash and buying peripheral bonds (e.g. Italy, Greece(. Hence, the optimism regarding a potential anti-fragmentation tool(s) might need to be tempered and this at a time when the Eurozone economy may be rapidly slowing down. What we do now about this tool is that it will almost be sterilized, that is not have an impact on the overall amount of money in the system.

What does it mean?

Given a likely somewhat risk averse environment, we continue to prefer the abilities of short-duration Covered Bonds but over time longer duration Covered Bonds should be of increasing interest. In addition, flexible fixed income solutions are dynamic in duration but also have a broader investment universe than just covered bonds. After a while, the spiral of risk taking in fixed income should slowly – and eventually rapidly – amplify as a rapid economic slowdown is fully priced in.

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