Weakening Growth Outlook to Eventually Favor Euro Rate Risk

European policymakers face a dilemma: continue to hike interest rates to combat inflation or ease off to stimulate growth. Across Europe, headline inflation has started to fall while the growth outlook remains weak. That combination would typically limit the scope for future rate rises and favor increased exposure to interest-rate risk (duration). We believe investors should prepare to back the beneficiaries of lower euro rates—but hold off taking big interest-rate risk positions for now.

We expect rates to stabilize in the second half of this year and fall later in 2023 or early 2024. Bond market prices will likely anticipate the changes, rewarding investors who have positioned their portfolios appropriately. But in the short term, there are several factors that urge caution before taking aggressive rate positions.

ECB Remains Under Pressure to Stay Hawkish

Despite falling headline numbers, core inflation in the euro area remains high, which will likely keep the European Central Bank (ECB) hawkish. And from a technical perspective, both UK and euro-area governments’ funding needs are rising, resulting in much higher sovereign-bond issuance (Display).

This coincides with the end of quantitative easing (QE) and the start of quantitative tightening (QT), increasing the publicly available supply of bonds to unprecedented levels and creating uncertainty about how markets will digest the elevated volume, particularly in the 20- to 30-year part of the curve.