European yields have experienced a challenging quarter. Events in the Middle East triggered a global reassessment of inflation expectations and the consequent central bank reactions. European bonds underperformed their US counterparts, with bonds from peripheral European countries posting particularly disappointing results.
WHAT THE ECB IS DOING
Although the European Central Bank (ECB) kept interest rates unchanged, its tone has become more hawkish as policymakers focused on signs of price pressures. With the surge in oil prices, memories of the 2022 energy price shock resurfaced prominently in investors’ minds, causing a sharp rise in short-term yields. The yield curve flattened markedly, with two-year Bund yields rising by nearly 50 basis points (bps) and 10-year Bund yields increasing by about 15 bps over the quarter.
INFLATION RISKS
Inflation risks are skewed to the upside. Oil prices have been elevated for several weeks and, if they persist, could start generating significant second-round effects on inflation. The environment remains inflationary, with tight labor markets due to low unemployment levels and slowly rising inflation expectations. We may also see greater fiscal easing to protect households and industry from high energy prices. However, we do not expect a full repeat of the 2022 inflation shock. Europe now has a much more diversified energy supply chain and, although improving, economic conditions are not as robust as they were then. We continue to expect the ECB to raise rates once or twice this year, but the timing of hikes could shift to the second quarter.
HOW GERMANY IS DOING
There are clear signs that fiscal stimulus is beginning to impact the German economy. Germany’s ambitious spending plans are now materializing, with federal spending in January on defense and other infrastructure significantly higher than levels seen over the past two years. Early signs of recovery in German manufacturing data continue, with purchasing managers’ indices exceeding the 50-point threshold that separates expansion from contraction for the first time in three and a half years.
GERMAN BUNDS AND BEYOND
We expect steeper European curves and higher yields. In line with this view, we maintain short positions on German Bunds along with a structural bias towards curve steepening, as the long-term implications of geopolitical conflicts indicate greater inflation risk and elevated fiscal term premiums, which should increasingly be reflected in yields and along the curve. Peripheral European countries struggled this quarter, with spreads versus German Bunds widening across the region. We believe this is a short-term reaction to macroeconomic news and fears that growth may stall in the near term. Overall, however, we continue to expect stability in European spreads as fiscal discipline remains on track.
