Global Daily – Another round of ECB re-pricing

by: Nick Kounis , Aline Schuiling , Bill Diviney

ECB View: Change of forecast: first hike now seen in December 2019 – As mentioned in an earlier note, we now expect the ECB to raise its deposit rate in December of next year (by 10bp to -0.3%). We previously expected a September 2019 move. The change in view reflects dovish ECB communication as well as the likelihood that core inflation will undershoot the central bank’s forecasts. This change has consequences for our rates views as it implies another round of ECB re-pricing (see below).

Ostensibly, the ECB’s communication is consistent with a September 2019 hike. However, there have been signals from officials that it will come later. ECB President Draghi stressed that ‘through the summer’ was the minimum period that interest rates would be left on hold. In addition, Vitas Vasiliauskas – a centrist in the Governing Council – noted that ‘in this part of the world, summer means until the end of September’. Furthermore, he asserted that ‘from the current perspective, maybe we can think about the possibility to discuss further steps in autumn’. He then stressed that he had said ‘discuss’ a move in the autumn, rather than actually make a move by then.

Meanwhile, we expect core inflation to continue to undershoot ECB projections. We judge there is still significant slack in the labour market in the eurozone on aggregate, which should continue to dampen wage growth. (Nick Kounis & Aline Schuiling)

Euro Rates: Flatter curves in the coming months, modest rise in yields later – Financial markets are currently pricing in an earlier start to the rate hike cycle than our new baseline scenario. There is more than a 10bp rate hike priced in for October 2019, while a significant probability is priced in for the July/September meetings. So if we are right about our ECB call, there should be a second leg of ECB re-pricing over the next few months. What impact will that have on fixed income markets? Given that no rate hikes are priced in any case for the coming year, we do not expect to see a big impact on the short end from any ECB repricing. Rather, we would expect to see lower German 5y and 10y yields over the next three months. We have reduced our 3-month forecasts by 30bp, to -0.4% for 5y yields and to 0.2% for 10y yields. That means we should see 2s5s and 2s10s flattening over the next few months. The various risks that continue to linger (such as a further escalation of Italian credit risk or protectionist measures) could also contribute to flattening pressure. Later in the year, as growth firms, and assuming some easing of risks, we assume a re-steepening, with 10y yields rising to 40bp by year end. We continue to expect swap spreads to remain elevated, as the QE ‘stock premium’ will persist. We expect the spread between 10Y Italian yields and their German counterparts to remain elevated (at 250bp), with risks skewed to the upside. (Nick Kounis)

US Rates: Somewhat lower yields on a more uncertain environment – Alongside changes to our European bond yield forecasts, we are also making some small adjustments to our 10y US Treasury yield forecast. The more uncertain global backdrop – driven by the persistent risk of an escalating trade war, but also by risks relating to the new populist government in Italy (see above) – has led to a drop in yields recently. We expect these risks to be a continued drag on yields over the coming months. As such, we have lowered our 3-month forecast by 20bp to 2.90%, and our year-end forecast by 10bp to 3.10%. Our 2y yield forecasts remain unchanged (Q4 18: 2.95%), reflecting our unchanged Fed call – we expect the Fed to continue hiking at a quarterly pace until next June, taking the upper bound of the fed funds rate to 3.00%. However, as we highlighted in our note What could trigger a Fed pause?, should trade tensions drive a significant decline in business confidence, the Fed would likely pause in its hiking cycle – and this would correspondingly weigh on 2y yields. This is a risk scenario and not our base case, however. As a result, our central view is that we will see continued 2s10s flattening in the US curve in the coming months. (Bill Diviney)