Rates Spark: Feeble pushback

Markets are still pricing more than three 25bp cuts over the next year, and more than a 50% chance discounted that the first cut will already come in April. By June, it is already fully priced. We have had pushback over the past few days from European Central Bank (ECB) officials, but aggressive pricing shows it has had limited effect. The hawks were signalling again that hikes are not off the table. More centrist members seemed to downplay these chances but still stressed persistence. Francois Villeroy, for instance, stated that rates should plateau for the next few quarters. More interesting were discussions surrounding ending PEPP reinvestments sooner picking up again.

The minutes of the October ECB meeting confirmed the messaging around the key rate – that hikes are not entirely off the table. But the reality is also that the “disinflation process was proceeding somewhat faster than expected”, while the ECB is not as optimistic about the macro backdrop anymore.

Amid all the central bank messaging, we should also note that financial conditions remain relatively tight, at least when measured by real interest rates. The 2Y real OIS is just 10bp shy of this cycle’s highest levels. At the longer end, the 10Y is well off the September spike but still higher than any time before that. This is thanks to the market inflation expectations component having come down notably from its highs over the past two months. Overall, it might lessen the need for officials to push back more aggressively, although some would point out the often-cited fragility of inflation expectations.

Yesterday’s flash PMIs remained in contractionary territory but notched up a bit and signalled that the downturn is not worsening. For market interest rates yesterday, that was enough to start turning somewhat higher again.

As we head into the final months and weeks of the year, bond supply prospects move into focus. But this time around, there is increasing uncertainty surrounding the outlook for issuance of German Bunds after the constitutional court derailed the government’s budget plans.

The downside risks are obvious, but we still have to get a clearer picture of what the ultimate impact is – not just in terms of supply but also for fiscal stance and the macro outlook as a whole. The political fallout is brewing, too. Members of the Free Democratic Party (FDP), which currently holds the finance ministry within the government coalition, have successfully petitioned to get a vote on whether to leave the coalition. The outcome would be non-binding for party leadership, though.

Yesterday, the finance minister announced that he wants parliament to retroactively declare an “emergency situation” for the current year, which would also allow for a suspension of the debt brake for the 2023 budget. This prospect gave Bund yields an uplift and retightened the Bund asset swap spread. But this plan is largely an after-the-fact legitimisation of 2023 borrowing given few other viable options and does not mean more debt issuance. The more relevant announcement of the 2024 budget has been postponed.