Rates Spark: Eurozone PMIs will test positive macro sentiment

Data surprises have turned more positive for the eurozone recently and the round of PMIs today will be the next test. The last reading of the eurozone PMI composite index edged above the 50 break-even level again thanks to an uptick in manufacturing. But overall, the manufacturing industry continues to show signs of weakness with the German index in contractionary territory for over two years now.

Markets seem in good spirits in terms of the growth outlook and would not be happy to see a turn lower in PMIs. Equities have shown an exceptionally strong performance this year and credit spreads have tightened further. Yet we shouldn’t forget how quickly sentiment can turn. November last year saw rates significantly below today on the back of mounting growth concerns, both in the US and eurozone. One round of weak PMIs was enough to justify an additional rate cut by the European Central Bank in October.

Since the lows in November the ECB has cut the policy rate by another 50bp, limiting the potential impact from PMIs on the front end of the curve. Recent hawkish comments by the ECB have pushed back against the idea of cutting below 2%. Markets have stuck to the view that the ECB will land between 1.75% and 2% for some months now and breaking that range would need more than one bad PMI reading. And if the weakness were to be driven by Germany, the usual suspect as of late, then the foresight of elections this Sunday may overshadow a downside surprise.

The expected ramping up of military spending has pushed bond yields higher, and in the case of Bunds, the relative pricing to swaps is at its cheapest levels. The uncertainty ahead of the German elections and the implications for the constitutional debt brake were another factor pressuring Bund valuations. The outcome, and in particular the performance of smaller parties, will determine whether those in favour of – or at least open to – reforms of the brake will have the necessary votes. Looming large is also a fear that the right wing AfD could perform better than polls suggest.

Even if a majority for reforms is obtained, we have the feeling that after all the headlines also surrounding the military spending, markets might overestimate the extent of the reform and also the timelines that might still be involved – starting with the formation of the government and then moving to the actual topic itself. Remarks from the election front-runner CDU suggest that other options of finding the financing, such as savings, should be prioritised first. The initial market reaction might be to still cheapen Bunds relatively, but we see a chance that such a move could be short-lived.