The fall in European inflation to 2.4% in November marks a turning point for monetary policy, and there is little doubt that the peak in key interest rates has been reached and that the European Central Bank will begin its cycle of declines in the coming months, probably as early as Spring 2024.
Short rates are nearing a neutral level
The recent decline in long-term rates in the euro area has reinforced the inversion of the yield curve. Short-term rates, strongly impacted by the ECB’s key rates, are still stable at 4.5% and exceed 3.5%.
On the other hand, long rates, which follow the US trend and anticipate a fall in future rates, are mostly traded between 2.0% and 3.0% for ten years. Expected declines from the ECB should flatten the curve further.
With our economies at a standstill and inflation closer to its targets, there is little doubt that the ECB will bring its policy rates back to levels it considers more neutral for the economy. With a growth potential of around 1% and an inflation target of 2.0%, this level should be about 3%. Investors expect them to be at this level by the end of 2024.
Will the ECB be able to lower its key rates even further, adopting a more expansionary policy?
This is not impossible, but a return to the ultra-expansionist policies of the past seems unlikely. On the one hand, the underlying trends that have allowed years of deflation or reduced inflation are threatened.
Globalisation is under pressure. While friend-shoring (bringing production from China back to closer places and countries that share our values) can make our supply chains more resilient, it comes at a price and is often less efficient.
Then, even if the conflict in Ukraine ends, it is difficult to see a return to cheap hydrocarbon supplies from Russia. This would be contrary to American and European interests and is, in any case, linked to its new sources of supply by very long-term contracts.
Let us add very tight labour markets, including right now, when our economies are at a standstill. The unfavourable demographic profile of the European workforce means that any increase in demand will result in a risk of overheating of the labour market and, therefore, of prices and the economy. Finally, it must be borne in mind that the energy transition and the protectionist measures that Europe is currently considering to curb the growth of imported products will have a cost which the consumer will bear.
For these reasons, a sustainable return of inflation to the levels that marked the pre-pandemic decade needs to be more timely. Therefore, the ECB will have to comply with a sure normality.
Long rates: more unknowns
The fall in short-term rates and the decline in long-term rates in the United States will have a downward trend effect on longer-term debt. Beware. However, the markets now expect no less than five rate cuts in the United States for the whole of 2024 (!), and therefore key rates at 4,25% at the end of 2024, while the Fed continues to be cautious and two or three declines seem more plausible at this stage. Investors are, therefore, going a little fast and may be disappointed.
But to know where the European long-term rates will go, other factors will also play. First is debt, which remains very important in the euro area (90.3% of GDP in the second quarter), even if it is calculated concerning a nominal GDP boosted by very high inflation in recent years. In absolute terms, it increased by $425 billion over the past year to $12,604 billion. The reason is simple: if the budget deficit of the euro area does not exceed 3.3%, this is due to countries such as the Netherlands (surplus of 0.2%) or Germany (deficit of 2.6%). Others, such as Belgium (deficit of 4.1%), Spain (4.4%), or France (4.6%), have taken a liking to the exceptional expenses of recent years (first to cope with the pandemic, then to reduce the consequences of the war in Ukraine) and show enthusiasm for returning to balanced public accounts.
The amounts to be financed are therefore increasingly important.
The question is whether investors will be willing to invest in such debt and at what cost?
This question is all the more urgent because, in the logic of normalising the ECB’s monetary policy, it is difficult to envisage that it leaves its balance sheet at current levels. At the beginning of the year, it had nearly 5 trillion assets on its balance sheet, including 2/3 linked to successive asset buyback programs. To get an idea of the impact of this presence on debt markets, suffice it to say that to finance their 10-year sovereign debt – one of the safest financial assets in the world and pillar of global finance – the United States pays 4.2% interest. Over the same period, Portugal finances at 2.8%, Spain at 3.2%, Greece at 3.3% and Italy at 3.9%.
Therefore, the ECB's presence on the debt markets keeps interest rates on European sovereign debt artificially low, even though it has gradually withdrawn since March. If this movement continues – and everything leads to believe it will – the ECB will have to be replaced by other players. And here again, the question is whether the European debt will be able to attract them and at what cost.
This is especially the case since Europe is far from isolated: everywhere, the debt continues to rise, and the competition to finance it is fierce; investors feel free to abandon those who do not demonstrate fiscal and fiscal responsibility. The United Kingdom has learned the hard way. The country has resolved to return to greater budgetary discipline since Liz Truss’s brief transition to government, which has resulted in a wave of panic over British debt.
Sooner or later, some countries in the euro area may suffer the same fate. A risk is increased because the idea of bearing a joint debt remains challenging for some. For all these reasons, it is less confident that a normalisation of European monetary policy will significantly decline long rates. If a decline remains the most likely scenario, we expect it to be less than that of short rates.
After very disappointing years, marked by a rise in interest rates that resulted in significant losses on the prices of European bonds, they are recovering a little, taking advantage of the prospect of lower interest rates in the future.
Make no mistake: while short rates keep a large margin to fall in 2024, long rates - based on our portfolios - seem much more limited. Therefore, the place we dedicate to the European bond within our fund portfolios still needs to be improved.
Overall, we prefer other debt markets, which are more profitable or have a higher potential for gains, such as the American one.
On the other hand, the sovereign bond in the euro keeps a shallow level of volatility in its favour and the absence of any exchange rate risk. It, therefore, remains the pillar of our defensive portfolio and helps limit risk within our balanced portfolio.
