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Yields on Eurozone government bonds continued to rise this week. This continued a sell-off that began at the beginning of March, triggered by the war in Ukraine. Immediately after the outbreak of war, safe government bonds were still in demand. This turned around relatively quickly, however, as the market shifted its focus to the additional inflationary pressures as a result of the war. Rising commodity prices are the most obvious economic impact of the war, but this could be compounded by additional price pressures from supply shortages, such as the COVID-19 pandemic triggering a shortage of semiconductors, which in turn led to rising vehicle prices. The war will thus both directly increase inflation rates and increase future risks.
At the same time, these factors also pose significant risks to the economy. The sharp rise in energy prices is putting a strain on household purchasing power. The economic viability of companies with high energy consumption has been called into question. Supply shortages could lead to production cutbacks or stops. The demand for certain goods and services that have a high share of raw materials could suffer. So, the risks of economic damage are also considerable.
We see two reasons why the market is nevertheless focusing on inflation. One is that the impact on inflation is already clear, such as the massive jump of the inflation rate in the Eurozone in March. The other is that the ECB and – even more so – the US Fed are more concerned about inflation. Unlike the US Fed, the ECB is moving very slowly, but the recent decision to taper securities purchases more quickly and possibly end them in 3Q was a step away from the current ultra-loose monetary policy, despite the war.
We believe that risks to the economy are currently not properly priced into benchmark German Bunds. Due to the above-mentioned factors and the rise in medium- and long-term interest rates, weaker economic data seems likely during the coming months. This should trigger a countermovement after the sharp rise in yields and lead to a decline in yields for medium and longer maturities. At the upcoming meeting of the ECB Governing Council in mid-April, a verbal dampener for yields could also come from this side. Yields of short-term maturities, on the other hand, should continue to rise, as we expect interest rate hikes in the Eurozone to start in December, but later than the market is currently pricing in.
In the US, yields have also risen massively in recent weeks. In contrast to the Eurozone, however, yields on short maturities have risen significantly more than those on medium and longer maturities. As a result, there is virtually no yield difference any longer between the 2-year and 10-year maturity. The market is thus pricing in the peak of the economic and interest rate cycle. The US market thus seems to be better prepared for somewhat weaker economic data. We therefore expect a sideways movement for medium and longer maturities over our forecast horizon. Yields on short maturities should still rise somewhat, but less than the market is currently pricing in. In our view, it is questionable whether US key interest rates will continue to rise in 2023.
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