The trend of falling inflation will encourage the ECB to make cuts in September
22 JUL, 2024
By Mauro Valle from Generali Investments
By: Mauro Valle, Head of Fixed Income at Generali AM, part of the Generali Investments ecosystem
At their July meeting, the ECB did not cut rates, as widely expected, and reiterated their data-dependent approach. Lagarde stressed that the September decision is entirely open-ended and will depend on data, primarily inflation data. Our view remains unchanged: the next cut will likely take place in September, when the new macroeconomic forecasts for the Eurozone will be published and wage data (which are seen to be moving in the right direction anyway) will be available. Although the latest Eurozone inflation data did not show clear signs of a downward trend, the ECB president confirmed their expectations to see inflation at 2 percent during 2025. Also, to be monitored will be the macroeconomic performance of the Eurozone, which after a positive first quarter, mid-year is showing signs of a marginal slowdown. Finally, the FED's decisions for a first rate cut in September will also support the ECB's decisions. The likelihood of a U.S. rate cut increased in early summer after seeing better-than-expected inflation data and labor market data gradually weakening, albeit in a very limited way for now. Powell has said that his decisions will more carefully balance these two aspects, and in his speeches, we always note a certain inclination to cut as soon as macroeconomic conditions allow.
We expect that in the second half of the year Euro rates should consolidate or slightly decline, but we do not expect conditions to go below 2 percent in a stable manner. The declining rate environment should favor investors' search for yield, and the current level of yields represents a good opportunity for investors. We also expect that the Eurozone yield curve, which throughout the first half of 2024 has shown an inversion level averaging about -40 bps, may dis-invert due to the less restrictive stance of central banks.
In June, markets were taken aback by Macron's political move to call early elections, pushing the OAT-Bund spread up to 85 bps (+40bps), also impacting the Italian BTP spread, which came in at 157bps. In the following weeks, after the election results did not lead to a clear political majority, volatility fell, with spreads returning up to 65bps, as the worst-case scenario for markets was avoided, namely an extremist majority with the risk of too much government spending. However, the lack of clear leadership in the French government will make the process of deficit reduction, as demanded by the European Union, rather difficult, with the risk of rating agencies questioning France's AA rating. The spread of Italian bonds, after having largely returned to the range observed during 2024, is still rated positively, and there is currently no evidence to say that BTPs cannot continue to consolidate in the second half of the year as well.
Government strategies continue to prefer a long duration positioning as we are constructive on euro rates for several reasons. In our view, the high carry level presents a good opportunity for yield-seeking investors, and we expect that with a downward trend in inflation accompanied by further cuts by the ECB, euro rates can continue to fall. In addition, we remain overexposed to peripheral bonds, with a preference for Spain and Greece. As for BTPs, in recent weeks we prefer to position them overweight relative to French OATs (itself underweight) in order to have modest net exposure to these two countries, given the risk of seeing other phases of volatility, especially after the summer break.
A final consideration concerns geopolitical risk, which has been a feature of markets since February 2022 and could always be a source of volatility for financial markets. For investors seeking diversification and a hedge against the volatility of risky assets, government bonds in recent years have returned to the role of an investment with defensive characteristics that can give some degree of hedging against negative events that might occur.
