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The bond market rally continued in the past month, with European yields declining substantially. The 10Y Bund yields are currently trading 30-40bp below the levels at the start of the year, and the market is now pencilling in that the ECB will cut policy rates by 150bp next year. Just a few months ago the expectation was for a decline of 65bp.
While we consider the fall in yields to be overdone, we concede that both US and European data have brought rate cuts closer. Inflation continues to decline in the Eurozone and the US, with price pressure easing in even the most entrenched elements of the consumer price indices (such as service prices). Underlying inflation also weakening is important for the central banks and clearly had an effect on December’s interest rate meetings, where the debate on more rate hikes seemingly evaporated completely.
Signs of inflationary pressure easing in the developed economies have left their mark on the rhetoric of those central bankers who until quite recently appeared very much open to further interest rate hikes. Perhaps the most obvious example in the past month was the change in tune from Isabel Schnabel, a key member of the ECB’s Governing Council, who essentially took the prospect of more rate hikes off the table when she said: ‘When the facts change, I change my mind’, a marked shift from her recent hawkish tone.
But have the facts really changed sufficiently in just a couple of months to warrant such a drastic repricing of interest rate expectations in the market? We are sceptical, as the sources of inflation outlook uncertainty are essentially still in place. Labour markets in both the US and Europe have proved remarkably robust to the economic weakness we have seen this year, and US economic data, in particular, remain surprisingly resilient to higher interest rates. In our recent economic forecast, Nordic Outlook, 5 December 2023, we expect the global economy to continue to grow below trend in the coming year, as we have not yet experienced the full impact of monetary tightening. However, we are not expecting a crisis.
Drop in long yields appears to be behind us
As mentioned, our view is that market developments have recently overtaken reality. The roughly 150bp worth of rate cuts priced for next year would require a considerably grimmer economic environment than currently appears to be on the cards. While growth signals in Europe are – admittedly – weak at the moment, we do not envisage a major crisis materialising. European consumers are increasingly benefiting from rising real incomes that are a direct result of accelerating (nominal) wage growth and slowing inflation. This will likely bolster purchasing power in 2024 and support the economy in tandem with high employment and generally high levels of savings.
We expect the ECB to cut policy rates by 3x25bp next year, kicking off in June – so, around half of what the market is pricing right now. The ECB’s relatively cautious message at its December meeting, balancing the risks with the expected resilient economic outlook, increased the likelihood of rate cuts starting earlier, but regardless of the timing, rate cuts will probably be initiated to ensure a soft landing rather than as a response to a major economic downturn, in our view.
We expect the long end of the yield curve to be especially sensitive to any repricing of the rate cutting cycle. This is also linked to a series of market dynamics that helped send long yields considerably higher in the autumn. While the US debt challenges are still daunting, overall government debt issuance in Europe also looks set to remain high in 2024. If markets have to reprice policy rates higher while absorbing an increased supply of bonds, the scene may well be set for greater volatility in bond markets. The term premium on long bonds would be particularly sensitive to this scenario, in our opinion. We still forecast 10Y Bund yields at 2.35% on a 12M horizon compared with a current level of 2%, while we expect US 10Y Treasury yields to rise from currently 3.9% to 4.20%. We look for slightly lower rates and yields at the short end of the swap/government curves on the back of our expectation that the initial round of rate cuts in both the US (100bp) and the Eurozone (75bp) will be delivered by the end of 2024.
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