Sébastien Galy, Senior Macro Strategist at Nordea Asset Management, comments on the current challenging situation for the ECB and European fixed income: “The ECB is likely to accelerate its pace of rate hikes, while an anti-fragmentation tool will eventually need to be built on conditionalities, namely much needed economic reform in the European periphery. This suggests some prudence on Eurozone sovereign long-dated fixed income. Over time though, as the economy slows and with it eventually inflation, the market is likely to turn ever more towards longer-dated fixed income. Eventually, it should also move towards High Yield, typically shorter-duration.

Eurozone inflation is currently 8.1% and the EURUSD is close to parity, meaning that the ECB has lost some credibility. Investors are clamouring for better compensation. As a consequence, the ECB has been slowly turning more hawkish - albeit far more slowly than many other advanced economy central bank. It hopes to win the battle of time when falling global demand leads eventually to a sharp fall in energy prices - which is a very risky strategy.

As the ECB turns more hawkish, it becomes questionable whether Italy or Greece can live with higher interest rates. While the first iteration of an anti-fragmentation tool should be presented in July, the open question from Bundesbank Nagel (Germany) is about conditionality, namely necessary economic reform in exchange for lower interest rates. You simply can’t give a blank check to the periphery.

The last result of this debate was the conditional Outright Monetary Transaction (OMT) facility, which was never used. Indeed, the current process of reinvesting maturing principals and coupons into the European periphery is unlikely to continue without a legal challenge. It is equivalent to selling core cash and buying peripheral bonds. Hence, the optimism regarding a potential anti-fragmentation tool(s) might need to be tempered and this at a time when the Eurozone economy may be rapidly slowing down.”