CONTRIBUTORS
David Zahn, CFA, FRM
Head of European Fixed Income,
Portfolio Manager
United Kingdom
The European Central Bank’s (ECB’s) January meeting seemed to mark a transition from the prior hiking cycle to cutting rates, but the central bank is not in any rush to do so. I think that was pretty clear. The Governing Council said it is “determined to ensure that inflation returns to its 2% medium-term target in a timely manner” and would remain “data-dependent.”
It seems most likely that June or July would be the preferred time to start cutting rates, as the ECB will want to ensure inflation is low and the economy doesn’t start to accelerate too much, which might push off the timing.
Markets in Europe have priced in 125 to 150 basis points (bps) of rate cuts this year, but I think that’s overzealous. I think 75 or 100 bps seems more likely. In my view, there is no reason to cut rates too dramatically, and the ECB can be more methodical and can review the data before making decisions.
I don’t see a March rate hike in the cards, but the market is still pricing in that possibility. Most of the fight against inflation is probably over—as long as there are no external factors that cause inflation to surge again, particularly food and energy. It’s now a matter of timing. The question is how long it will take to come down and how well-behaved wages are, which would give more scope to lower rates.
The three-month Euribor has priced in more rate cuts than I would anticipate, so the market will likely need to reprice slightly higher in yield. However, if you look farther out on the curve, whether the ECB cuts 75 bps or 100 bps this year, it isn’t going to make a huge difference. It is the very front end of the yield curve that will see a greater impact.
I would like to note that there is a lot of talk about the yield curve in Europe being inverted, but this is sort of a misnomer. It’s the German yield curve from two-year to 10-year and two-year to 30-year that is inverted, but France and Spain have good upward-sloping yield curves. So, the risk-free rates are slightly inverted probably for other reasons, but the general rate structure in Europe is upward sloping and doesn’t create much of a problem, in my view.
Locking in yield
Given rate cuts are likely ahead, I think we will see investors move to lock in yield for the next several years and move into longer-duration assets. In general, we should see many investors moving out of short-dated instruments. If they are in cash, they will probably move into short- duration investments, and if in short-duration, into longer-duration investments.
Looking at the impact on green bonds in particular, most are longer-dated when compared to conventional bonds. Most green bond indexes are about a year longer than similar conventional bond indexes. Green bonds had underperformed conventional bonds during the rate-hiking cycle, and I think they have scope to outperform considerably during the rate cutting cycle. The ECB will also likely be looking at greening its balance sheet, and there is desire for more robust infrastructure to generate power within home country borders. So, I see more green energy being built in Europe and more demand in that space from an investor standpoint.
In sum, I think the ECB has set up the bond market to have a decent year in 2024. It won’t be a straight line; there will be volatility as markets get accustomed to the change in the cycle. In addition, there are a number of elections across the globe this year, which could bring some short-term political noise. But volatility creates opportunity. We embrace volatility and manage accordingly. Currently, we are more focused on the core countries with better fiscal dynamics and that are more liquid—Germany, Austria, Belgium, as well as Spain.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Green bonds may not result in direct environmental benefits, and the issuer may not use proceeds as intended or to appropriate new or additional projects.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.