Flash Note : ECB AND EURO GOVERNMENT BONDS - UPDATE

Lauréline Renaud-Chatelain, Fixed Income Strategist, Nadia Gharbi, Senior Economist and Frederik Ducrozet, Strategist Pictet Wealth Management.

Hawkish pivot likely mean the end of negative yields:

Last week’s European Central Bank (ECB) meeting, clearly points it in a more hawkish direction. At its March policy meeting, we expect the ECB to announce the reduction of its net asset purchases from EUR40bn per month in Q2 to EUR20bn in Q3, with the whole asset purchase programme (APP) to be wound up by September at the latest.
Regarding policy rates, we now expect the ECB to bring its deposit rate back up to zero in two 25 bps rises in December 2022 and March 2023, before marking a pause. Looking ahead, core inflation that looks like staying higher for longer would point to a higher terminal rate than is being priced in by the market (at close to 0.60% on a five-year horizon).
The end of quantitative easing, coupled with market participants’ likely underestimation of the scope of the ECB’s hiking cycle, is leading us to revise up our forecasts for the 10-year German Bund yield to 0.2% at end-June and to 0.4% (from 0.0%) at year’s end.
The bond market reacted sharply to the 3 February ECB meeting, with the 10-year Italian sovereign bond (BTP) spread vs. the Bund shooting up by 21 bps to 160 bps in the following days (up to 7 February). The widening in peripheral bond spreads could slow the ECB’s policy normalisation, but is unlikely to derail it in our view.
Our simulations of the sensitivity of Italy’s debt-to-GDP ratio to movements in rates show the 'danger zone' for the 10-year BTP spread versus the Bund to be around 250 bps—still some distance away from current levels.
Although, we cannot rule out the risk that BTP spread levels reach dangerous levels, our main expectation is for the 10-year spread to settle between 150 and 200 bps this year as Italy’s growth trajectory is likely to remain robust and planned structural reforms are on track. As such, we are revising up our year-end spread forecast from 130 to 160 bps.