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Saxo Partner content: Stagflation builds the case for short-term real and nominal sovereigns

Germany and the Netherlands are in a recession, and PMI numbers paint an ugly picture for Europe. Yet, inflation expectations have slowly risen, showing that the ECB 2% target might not be plausible.

Within this context, the ECB will have its hands tied as it won’t be able to cut or hike rates, not to spur inflationary pressures, nor to drive the euro economy into a recession.

That means that front-term yields will be anchored for some time, while long-term yields might adjust lower as a recessionary picture develops.

Although things might be different for the BOE as another rate hike might be necessary, it is impossible not to acknowledge the attractiveness of short-term government bonds within this context.

As uncertainty remains elevated, we favor short-term European government bonds, especially inflation linkers, as inflationary pressures might resurface during the last quarter of the year.

·         The 2-year German swap remains elevated.

It indicates that market expectations are still anchored around a higher for longer rate scenario, providing little room for government bonds to rally. That explains the bull flattening of the European yield curve after the ugly PMI reading, with 2-year Schatz yields remaining around 3%. Indeed, while bond future markets have pushed back on bets of another ECB interest rate hike, they are still pricing a 10bps hike by September and 15bps by October.

Source: Bloomberg.

·         Europe’s inflation expectations have increased since last month

The problem the ECB is facing is that amid an economy in contraction, inflation expectations have increased within the last month. That builds a floor for front-term yields, while long-term yields are able to fall amid recessionary fears.

Source: Bloomberg and Saxo Group.

Short-term European sovereign bonds

Source: Bloomberg and Saxo Group.

Althea Spinozzi
Senior Fixed Income Strategist

The information in this article should not be interpreted as individual investment advice. Although Hugo compiles and maintains these pages from reliable sources, Hugo cannot guarantee that the information is accurate, complete and up-to-date. Any information used from this article without prior verification or advice, is at your own risk. We advise that you only invest in products that fit your knowledge and experience and do not invest in financial instruments where you do not understand the risks.

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